There are five general key areas of business performance that ALL businesses must do well at in order to thrive.
If a business is doing poorly in any one of these areas, it will show up in the overall operation of the business.
Finance is the ability to fund the business plan or the current financial forecast. I will present seven key financial parameters that I evaluate when reviewing any business.
Businesses come in all shapes and sizes when it comes to needed capital. Some require a large factory to produce goods. Such businesses require a substantial amount of upfront capital. On the other hand, a consulting business can be opened out of a home office with a few thousand dollars to pay bills prior to attaining paying customers. Either way, companies need to have and plan for capital to succeed.
Capital is not only important to start a business; it is equally important when considering rapid growth opportunities.
Cash is the amount of money in the checking account that can be spent right away on growing the company. Business owners run into trouble with cash flow when they collect payments from their clients slower than they pay their suppliers. The scary thing is that a company can be profitable and still run out of cash.
Here are a few common ways to increase cash flow:
- Ask for payment up front. Customers may pay for their service before they receive it. This is actually common with professional consulting or legal services. Clients pay what is called a retainer in advance of services. The next best thing is to ask for 50% payment up front and 50% after your service has been delivered.
- Delay payment to suppliers or subcontractors. It is a good practice to pay your suppliers and subcontractors only when you have received payment for their services from your customer.
- Borrow in the amount of your accounts receivables. If you have payments that are on their way, credit cards can buy you short amounts of time to hold you through these cash shortages. Be careful about caring balances on credit cards as the high credit card interest costs will negate most cash flow benefit.
- Loans. Banks will typically only loan you money when they know they will get it back. This means that you will have to have an asset as collateral, or receivables they believe will pay the loan. Use this as a last resort.
- Lines of Credit. A line of credit allows you to borrow money to cover your cash situation through low cash flow periods. The key is to get this line of credit long before you need it. Banks are unlikely to approve your line of credit in a cash emergency.
Cash supply is like oxygen, if you run out, the game is over.
If your price is too high, customers will not buy your product; too low, and you will be leaving valuable profit on the table. Most new small business owners are afraid to charge too much in fear of losing customers.
The reality is that there are many different consumers in the marketplace. Some will not want your product at any price. What most small business owners don’t understand is that if you price your product or service too low, many will think your product is too cheap and will not buy it.
The optimum price is often higher than the popular price. The pricing curve show above is a typical consumer response to price. If competition is high, a business owner will need to reduce their price to the popular price in order to compete. However, if a business has a less competitive market, they ought to charge the higher, optimum price.
To start, establish a price based on costs. Then check competitor’s prices. If you feel like you need to charge more than your competitors, be prepared to back up your added costs with genuine value. If you feel like you need to beat your competition on price, make sure you have figured out some efficient way to deliver comparable quality to your customers for less than your competition.
I’ve heard some business owners make the statement, “I’m not in it for the money”. This is either a sign of dishonesty, or a statement from a place of ignorance. Business owners do not need to be greedy, but they do need to make a profit. If not, they will not be long for this world. Profit margins range from 2% for large volume businesses like grocery stores and gambling casinos, up to 50% for consulting practices. The reason for such differences in profit margins has to do with the risk and the volume of business. Consulting firms have a high risk of billing hours; while grocery stores are almost guaranteed to move product based on a constant need within their community.
I know this sounds overly simplistic, but profit is simply the price customers will pay minus the cost it takes to produce your product or service. As we discussed in the previous section, you do have some control over the price you charge. However, customers will force price into a relatively narrow range. Business owners have a substantial amount of control over cost and production efficiency and can often drive profit by closely controlling costs without sacrificing quality.
A business owner can control costs to control profit. Most startup businesses who have limited capital are too frugal with their money; while established businesses tend to lose track of their costs. Direct Costs and Overhead Costs are the two types of costs that should be controlled.
Direct costs are expended on things that will directly benefit your client. These costs should be kept within a specific percentage of revenue. Professional service firms will often run a direct cost to revenue rate of 20% to 40%. Restaurateurs will run a food cost rate of 20% to 30% of revenue. Retailers will often have a direct cost rate of 85% on sold merchandise. It really doesn’t matter what this rate is as long as it is consistent.
Overhead or indirect cost is a little trickier. Overhead costs will not normally increase linearly with revenue. Some overhead costs precede revenue… .like sales and marketing. Some overhead costs are constant no matter what… like a high speed internet connection or office rent. Some overhead costs will rise slightly as revenue increases… like administrative support based on the number of employees in the company.
In order to control costs, a business owner needs to ensure that costs are controlled as planned. Otherwise, be prepared to see some red ink at the end of the year.
A study conducted by the University of Cincinnati reported that 64% of small businesses experience employee theft; and 16% of small businesses report such theft to the authorities for prosecution. Such theft is often successful before a small business owner can catch the thief; and can devastate a small business owner.
In order to prevent theft, small businesses must implement a system of controls… just like the big guys. Ratio checks on expenses; and double authorization for substantial expenses and many other controls can dramatically reduce the likelihood of theft. Most people know theft is wrong, but it is the business owner’s responsibility to remove easy temptations to steal.
If a business has too much debt, it can struggle making payments and will give up a substantial amount of profit to the bank. If a business has too little debt, it is most likely not taking advantage of growth opportunities. Most small companies are reluctant to go to a bank until they have sales to justify borrowing money for growth. Unfortunately, when banks see a cash-strapped company asking for money, they say NO. A business owner should get qualified for credit when they don’t need it. Then, when the do need it, they have the access they need.
(to be continued – Check back in a week for a continuation of this post)