The answer is both.
When entrepreneurs start their businesses, their natural focus is to drive sales and revenue but, in the process, they sometimes forget about measuring the quality of their earnings. There is an old saying which says: ‘turnover is vanity, profits are sanity and cash flow is reality’. Of course, no one wants to destroy entrepreneurial enthusiasm, but some warning signs are necessary. Too many businesses fail shortly after they are started, and it is not necessarily because of the business idea, but more often because of poor financial management of the business.
adding some science to your business
Let us investigate five areas in a business, where with some focus, the quality of earnings can be improved.
When we refer to the ‘vanity and sanity’ of turnover, we are calculating what gross profit is earned and at what margin? Gross profit should be the amount of money earned that is enough to exceed the overhead expenses in the business to make a net operating profit. So, let us assume that a business has a monthly overhead expense bill of $100,000 per month:
- a gross profit margin of 20.00% would require a monthly turnover of $500,000 to cover overheads by a factor of 5.00. Formula: 100.00% / 20.00% = 5.00
- a gross profit margin of 30.00% would require a monthly turnover of $333,333 to cover overheads by a factor of 3.33. Formula: 100.00% / 33.33% = 3.33.
Higher margins make overhead recovery easier. Of course, that assumes that a business can achieve higher margins. Increased margins generally tend to reduce sales volumes while lower margins increase sales volumes. Businesses need to consider the trading environment and tweak the dynamics to achieve an acceptable balance on earnings quality. The product and customer mix are important considerations and the leader needs to consider the following:
- do all products contribute to their full potential?
- will discontinuing low margin earning products have a detrimental effect on the business?
- do all customers contribute positively to the business?
- will closing low margin customer accounts have a detrimental effect on the business?
There is no right or wrong answer to these questions. The solution is to carefully measure the contribution of each product to each customer and ensure that the aggregate result is an efficient gross profit contribution to the business.
The difference between gross profit and net operating profit in a business is its operating expenses. Lower expenses obviously reduce pressure on gross profit margins and improve the opportunity to optimise net operating profits. There are two types of expenses: fixed and variable. Fixed expenses are generally those which are predictable in nature, for example, rent and salaries. Variable expenses are those which generally occur in proportion to turnover levels. Lower turnover, in theory, would therefore result in lower variable expenses. As a strategy, business owners should seek out ways to convert as many fixed expenses as possible to those of a variable nature. This strategy has the effect of protecting net operating profit to some extent when turnover is adversely affected for any reason. Conversely, the benefactors of variable expenses, for example salespeople, will benefit when turnover rises. These benefactors will then be motivated to drive turnover at an optimum gross profit margin. Reducing the dependence on fixed expenses can be measured by calculating the breakeven point.
To achieve profits, businesses need to borrow money to finance either fixed assets or working capital requirements. Borrowing costs money in the form of interest and once the interest is deducted from the net operating profits, the taxman wants his share. There is very little one can do about paying tax, except to ensure that all legally allowable deductions are processed. When it comes to borrowing money, business owners have some options besides hard bargaining to reduce the rate of interest charged. Borrowings options include the following key instruments:
- term loans – term loans are usually raised to finance startup ventures or projects which are projected to generate sustainable cash flows before the term loan is paid up
- overdrafts – overdrafts are put in place to finance fluctuations in working capital requirements such as inventory and receivables
A key ratio in measuring the affordability of interest payments is called interest cover. Interest cover measures the number of times the interest cost is divided into the net operating profit. Higher ratios are rewarded with lower interest rates.
Now we have moved on from the trading account and the income statement to the balance sheet. A balance sheet is a statement of an enterprise’s financial position at a point in time. It shows the two sides of the financial situation – what the business owns and what it owes. Expressed as an equation, total assets equal the sum of non-interest-bearing debt, shareholders’ equity and interest-bearing debt. The net assets element of the balance sheet is calculated by deducting non-interest-bearing debt (current liabilities) from the total assets. This is a useful element to measure because it can be controlled by people who do not necessarily have any influence on formal borrowings and their terms. So, a key measurement is the return on net assets. Return on net assets is measured by dividing net operating profits by net assets. Higher returns indicate greater efficiency, which lead to reduced balance sheet funding requirements, thus leading to reduced interest charges.
Let us examine the components of the return on net assets formula (ROA)
The objective is to optimise the return on net assets (ROA). This can be done by addressing one or more combinations of these components:
- increasing net operating profits
- reducing fixed assets
- reducing inventory
- reducing receivables
- increasing payables
By using these formulae, it means that if margins in a business are high, asset turn can afford to be lower to achieve a desired ROA. Conversely, if margins are low, asset turn needs to be higher to achieve the desired ROA. Incentivising employees responsible for optimising ROA is probably a good investment.
The final area to investigate on how to improve the quality of earnings of a business is to focus on how it is funded. There are two key funding ratios:
return on equity
This ratio measures the percentage of taxed profits earned from the shareholders’ equity at the beginning of a financial year.
debt / equity
This ratio presents the proportion of interest-bearing debt to shareholders’ equity in your business, which collectively equals the net assets. A value less than 1 means that the business has less interest-bearing debt than shareholders’ equity in the business. This ratio is driven by policy and is used to determine the strategic sustainable growth rate of your business. This ratio is usually considered when business expansion is on the table and, of course, when determining the value dividend paid to shareholders.
Develop your own financial model that allows you to measure the dynamics of your business. In my book, ‘getting to value’, I reference several Microsoft Excel spreadsheets, which I have created, and which can be downloaded from the bizzclass page in my website www.bizzbean.com. These spreadsheets can form the basis of your model and they also provide some useful lessons on how to optimise business efficiency.
Alternatively, you may consider purchasing my bizzdynamics app, which also allows you to learn and apply these lessons, but which is much easier to use. bizzdynamics is a business learning simulator. It is designed to show how changes to key business elements, such as contribution, expenses, asset levels and funding strategies impact the financial results of a trading business. You will learn by simulation and you can evaluate the results in the reports tab of the app, where these dynamics are explained.
Quentin G McCullough