Came across this article and thought in this current financial turbulent time, this may be of interest to others as well.
By Ben Fewtrell
Recently I was presenting to a group of business owners about understanding business financials, after I had stated that you can go broke making a profit, an audience member challenged me and asked how it is possible. So I thought it would be a good idea to cover the topic in this issue.
Firstly, we need to understand the basic fundamentals of business. You need to sell a product or service, and make a profit. A business is a ‘commercial, profitable enterprise that works without you’. You have probably heard the saying ‘Profit is king’ and also that ‘Cash flow is king’, so which one is true?
Well both are, here is a simple formula for business failure – No Profit x No Cash flow = No Business. To succeed in business you need to make sure you are making a profit and you also maintain a healthy, positive cash flow.
Secondly, we need to understand what going ‘broke’ means. In business being ‘broke’ is known as being ‘insolvent’. There are several definitions for this, here are some definitions I found after I Googled the term; ‘Not having sufficient financial resources to meet financial obligations’, ‘When liabilities are greater than assets’, ‘When a company cannot pay its debts when they are due’. Basically, when you can no longer pay your debts, you are insolvent!
Finally, you need to understand that some things you pay for end up on your ‘profit and loss’ statement and others end up on your ‘balance sheet’. An expense like rent will be entered as an expense on your profit and loss statement, but when you buy equipment that will last you several years, it gets entered as an ‘asset’ on your balance sheet, then each year you will claim depreciation as an expense, and if you took a loan out to buy the equipment, the loan will be entered as a ‘liability’ on your balance sheet. I’ll kick off with a simple example to make sure understand the concept.
Let’s say you own a coffee shop, and your fixed costs (rent, wages, electricity etc.) are $2000 per week, and you have a 50% gross profit margin (this is calculated by deducting your cost of sales from the sales amount). In this example you need $4000 in sales to ‘break even’, that is, pay your fixed costs of $2000 and the $2000 cost of getting the sales, your profit is zero. What if you were also repaying a loan for buying the business, the only part of this that will show on your profit and loss is the interest on the loan, the rest of the payment is reducing your liability on the balance sheet. All of a sudden, you are in a negative cash flow situation.
So how do you make sure you do not follow the many that have already mistakenly gone broke, whilst making a profit? The simplest way is to make sure you manage your money well, it is one of the resources you must have control of, or you may end up in trouble.
Here are some ways to make sure you manage to keep your cash flow positive…
* You need to have a cash flow forecast for at least 3 months in advance, this way you can identify problems before they occur.
* If you have customers that have ‘accounts’ with you, make sure you collect your money by the due date, don’t let customers drag out their payments to 60, 90 or even 120 days. You can even make special offers to customers that pay quickly. Sometimes it may be worthwhile considering ‘factoring’ your debts if your clients have a valid reason for taking a long time to pay.
* If possible, get your clients to pay a deposit upfront.
* Reduce your stock turn, this way you can make sure you are selling your stock before you have to pay your suppliers for it.
* Negotiate longer payment terms with your suppliers.
* Keep your costs to a minimum; avoid wasting money on things that are not necessary.
* Set a budget, and stick to it!
* Never borrow money just to ‘get out of trouble’, in most cases I have seen, this just makes the situation worse!
I would suggest that if numbers is not your strong point; get your bookkeeper or accountant to help you. Finally, if you do end up in situation where you cannot pay your bill(s), talk to your creditor(s) and make an arrangement, most people will understand and will let you pay it off, and if this fails you might need to get some professional help.