What if I told you there was a way to make more money in your small business without having to grow your customer or client base? Would it sound too good to be true?
Well, what if I told you that it's not!
Entrepreneurs are extremely busy. If you're a startup founder, a web3 business owner, or a professional that has ventured out your own (that's you veterinarians, dentists, chiropractors, optometrists and lawyers!), you have so much on your plate, that you are probably focussed on a singular objective: growth.
If you are focussed on growth you are focussed on revenue. And, unfortunately, that means you might be leaving a lot of money on the table, because you could be spending too much to achieve greater sales.
How can you tell? Profit Margins.
A profit margin, in business terms, is the amount of income that remains after accounting for all expenses related to making and selling a product or service. It's presented as a ratio in percentage terms.
Having high profit margins, means that can generate higher amounts of cash per sale, which you can then use to pay off debts, reinvest in the company or provide to shareholders as a return. Having low profit margins, means the exact opposite.
When looking at profit margins there are three main types that small business owners should look at:
Gross profit margin measures how much income is generated from sales after subtracting any direct costs. These include cost of goods sold like raw materials and direct labour. Gross profit is useful to look at on its own, as it shows whether a company is able to cover its overhead and by how much.
The formula for gross profit margin:
(Total Revenue - Cost Of Goods Sold) / Total Revenue X 100
Using this formula you can see the percentage of each dollar of revenue that a company retains after covering the cost of the goods or services it sells. For example, if a company has a gross profit margin of 25%, that means it retains $0.25 for every dollar of revenue it generates after paying its direct costs.
Operating profit margin measures how much income is generated from the core operations of a business. This metric can be used to determine a company's ability to generate cash flow and cover its operating costs.
The formula for operating profit margin:
(Total Revenue - Cost of Goods Sold - Operating Expenses) / Total Revenue X 100
Using this formula you can see the percentage of each dollar of revenue that a company retains after covering all of its operating expenses. For example, if a company has an operating profit margin of 15%, that means it retains $0.15 for every dollar of revenue it generates after paying its direct costs and operating expenses.
Net profit margin measures how much income remains after all expenses have been paid, including interest payments, income taxes, and depreciation. These last items are what set net profit margin apart from operating profit margin.
Net profit margin can be used to assess a company's overall financial health and performance.
The formula for net profit margin:
Net Income / Total Revenue X 100
Using this formula you can see the percentage of each dollar of revenue that a company retains after paying all of its expenses. For example, if a company has a net profit margin of 10%, that means it retains $0.10 for every dollar of revenue it generates after paying all expenses.
It's all fine and dandy to know what profit margin is and how you calculate profit margin, but how do you actually use these numbers to make more money? As we talk about in our Definitive Guide To Managerial Accounting For Small Businesses, you can't improve what you can't measure. Profit margin ratios provide this base of measurement.
From there you can:
So we know how to calculate profit margin and we know we should compare our profit margins to other standards in an effort to improve. But what are those standards? What are typical profit margins?
Out of any profit margin measure, gross profit margins vary the most, and there is a very wide range between industries. This is because of how gross profit margin is measured. Financial institutions, as an example, will have high gross profit margins because they have little in the way of true direct costs. While product based businesses, such as retail outlets or food stores, will have low gross profit margins for the exact opposite reason.
And we should also mention that having a low gross profit margin is not necessarily a bad thing. It simply means that these businesses have to have higher sales turnover to generate enough gross margin to cover their operating expenses.
With that all said, you can find good benchmarking tools online. Using tools like these, you can find measures to compare to. Using Ready Ratios you can see that:
Operating profit margins have less variance than their gross margin counterpart. This is because operating income includes most expenses, with the exception of interest and taxes. So regardless of how a business classifies its expenses, most are included in this measure.
Again, lower margins aren't necessarily bad, it just means that these companies need higher sales volumes to cover their interest and tax expenses.
Using Ready Ratios again, you can see that:
Net profit margins usually have even less variance as net income includes all expenses of a business. Using Ready Ratios data here, you can see that:
Knowing what typical profit margins are, you now need to know what your own margins are. You can calculate your various profit measures by using your company's income statement and using the formulas we provided earlier in this article.
You can now compare your margins to the benchmarks you selected. How do they stack up? Are they higher? Are they lower?
When comparing your numbers you really want to dig into why your numbers are different.
Knowing why your margins are different from the benchmark is important. This will allow you to make changes to your business operations that will improve them over time, and ultimately, this is what will start making you more profit for every dollar of revenue you earn.
There are many ways to improve your profit margin without growing your sales. You could:
Keep in mind that you don't need to make a bunch of big changes all at once. You want to repeat this review process on a consistent and frequent basis. When you do so you will be able to make small, incremental improvements that will add up over time. If you can do that, you will be making a lot more money without having to get any more customers a lot quicker than you think.
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You might have heard these grim statistics before: more than 80% of all small businesses fail within 10 years, and more than 80% of those businesses fail due to cash flow issues. While some dispute the exact numbers, the underlying issue can't be. Cash flow is important. Period.
One would think that one of the most important business areas would be well understood. That isn't the case though. Cash flow is still one of the most ill-understood topics within the small business community. And forecasting cash flow? Even though it is just as important, it is even more misunderstood.
Jump to a section of this post:
In this post we will shine light on these misunderstandings, talking about what cash flow is, what cash flow forecasting is, the different types of cash flow forecasting there are, and how forecasting your cash flow can greatly benefit your small business whether you're a founder of a startup or a web3 company, or a professional that has ventured out on their own (say a veterinarian, dentist, chiropractor, optometrist or lawyer).
So, let's start with the basics: what is cash flow?
Cash flow is simply the movement of money in and out of your business. Money coming in is called inflow, while money going out is called outflow. Your business' cash flows can be positive (more cash inflows than outflows), negative (more cash outflows than inflows), or neutral (equal cash inflows and cash outflows).
The movement of money within, and through, any business is extremely important. At a basic level, every entrepreneur sets out to make money. So stripping everything down, each business' ability to generate positive cash flow, consistently over time, determines just how good that business is performing.
The more cash flow a business can make, the better it is doing.
Now, the above discussion on the importance of cash flow might seem overly simplified, and it is, but most small business owners don't have a great handle on this basic construct.
And there are two reasons for this:
Double entry accounting underpins all accounting as we know it. It requires that every financial transaction to be recorded in at least two different accounts. For example, when you make a sale, you would record this transaction both in your sales account on your income statement and your cash account on your balance sheet.
While this system provides greater accuracy and transparency around business finances, it also makes measuring cash flow more difficult. And that's because changes in cash can occur in two places: your income statement or your balance sheet.
There are two basic methods of accounting: cash accounting and accrual accounting.
Cash accounting only records transactions when the actual cash changes hands. So if you make a sale and the customer pays later, you wouldn't record that transaction until you collect payment from the customer.
Accrual accounting records income and expenses as they are earned or incurred, regardless of when any actual cash is received or paid out. Using our same example, if you make a sale and the customer pays later, accrual accounting would record the sale right away and create an accounts receivable. It would then eliminate that receivable and increase your cash balance when you collected payment.
Accrual accounting is a double edged sword. It creates financial statements that are more accurate and reliable for various users, but also creates timing differences, estimates and other complexities that aren't necessarily well understood by business owners.
The cash flow statement is the report that helps overcome the shortcomings that accrual accounting and double entry accounting processes make. This report ties the balance sheet and income statement together within your typical financial reporting. It measures all cash inflows, all cash outflows and eliminates any non-cash estimates that are also contained within your financials. And ultimately it reconciles all of this information to the cash balance contained within all of your bank accounts.
You can see two different forms of cash flow statements: those using the direct method and those using the indirect method.
Cash flow statements using the direct method are considered by some to be more accurate. This method reports all cash inflows and cash outflows from your business operations separately from any other inflows or outflows. This could include things like customer payments, vendor payments, interest income, dividends and other operational items.
The indirect method is a bit more simplified. It adjusts your net income for any timing differences between when you record accrual based items and when the actual cash is paid or received. This reconciles your net income to your actual cash. While this method isn't as detailed as the direct method, it's also not as susceptible to error.
Regardless of the method used, cash flow statements are a very important piece of your financial picture. As mentioned previously, they show how cash moves through your business. That said, cash flow statements are historical in nature. They show you what your business did, but not where your business is going. To see that kind of information, you will want to use a cash flow forecast.
A cash flow forecast is a projection of all of your future cash flows. It is a best guess, based on all available information, of what you expect to happen in the future. This includes things like expected:
A good cash flow forecast will show you:
This will give you a clear picture of where your business is heading, and how much cash you will have on hand at any point in time.
We touched on some of the high level benefits of cash flow forecasting in our Definitive Guide To Managerial Accounting For Small Businesses. Simply put, knowing the future net cash flow of your business, and your estimated cash balance at any point in time gives you a lot of power as a business owner. You will be able to:
By forecasting cash flow, you can see when your business might have a shortfall of cash. This allows you to take steps to avoid or mitigate the effects of a cash shortage, such as delaying expenditures, extending payments on accounts payable or shoring up working capital with short term debt.
Cash flow forecasting will give you a better understanding of how money moves within your business allowing you to more effectively manage your activities with operating cash. This can be particularly helpful if your business:
Knowing when and how you will get paid, and how and when you will make payments will make you a lot less reliant on debt and lines of credit.
A cash flow forecast will give you a better understanding of your business's financial health. This information can then be used to make better informed decisions about how to best use your resources.
Do you have enough cash to buy the equipment you need to grow and hit your sales targets? Can you afford to hire that stellar employee you interviewed? If you open a new location how will that impact your bank account in the short and long term?
Whether you have negative cash flow or a host of cash surpluses, thinking through exactly how you will progress your business, and knowing the effects of these decisions is an extremely helpful exercise. It will surely boost your confidence.
A cash flow forecast will help you track your progress towards your strategic business and financial goals. The information gleaned from the cash flow forecasting process itself can be used to adjust your budgets and your business plans, making these documents dynamic and more relevant as your operations change.
There are a number of different types of cash flow forecasts. Just like cash flow statements there are different methods you can use to create a cash flow forecast. And depending on your goals, the time frame you use in your cash flow projection should change.
Similar to its cash flow statement counterpart, a direct forecasting shows the exact cash inflows and outflows that result from your business' operations. This is the more straightforward approach to cash flow forecasting as it directly ties to all incoming cash receipts and outgoing cash payments.
Indirect forecasting does not start with your business' operational cash inflow and cash outflows. Rather, it begins with your company's net income figure. From there, non-cash items and changes in working capital are added back into or deducted from the bottom line to get to a net cash flow figure.
Indirect cash flow forecasting is more common associated with three way cash flow forecasting. This cash flow projection method forecasts your income statement, balance sheet and cash flow statement and ties them altogether. Hence the term three way forecasting.
Three way cash flow forecasting is sometimes viewed as the most robust way to cash flow forecast. It eliminates a lot of possibility for errors, especially when using a spreadsheet, and also presents bank ready financial statement projections that can be used for lending purposes. This method is typically a lot more customized however, can take a lot more time to create and maintain, and sometimes isn't as easily understood by entrepreneurs.
Long term cash flow projections are typically forecast from one year to five years out, with most going to three years in range. This type of cash flow forecast is most often associated with strategic planning and indirect/three way cash flow forecasts. These types of estimates are often used to:
A short term cash flow forecast is much more operational in nature. It can range from days to months in terms of time frame, and often does not go beyond a year. This type of forecast is much more granular in nature, and has much more accurate information in terms of timing. It is often updated quite frequently, as regular as weekly forecasts or daily, and is ultimately used to answer the question "do I have enough cash to do X?" in the near term.
The biggest difference between a short term and long term cash flow forecast is its use. Long term forecasts are more strategic, while short term forecasts are more operational.
The best analogy is a road trip using a map. A long term cash flow forecast determines exactly where you are going and loosely determines how you will get there. A short term cash flow forecast is used while you are driving to that destination, constantly shifting due to traffic, construction and road closures.
It is often a best practice to use both a long term strategic and a short term operational cash flow forecast.
An accurate cash flow forecast can be a game changer. Whether you're a professional, such as a veterinarian, dentist, chiropractor, optometrist or lawyer, or a founder of a startup or a web3 company, you will experience cash flow issues. Studies show that the vast majority of business owners have at least once in their lives.
Knowing exactly when that cash flow issue will come, and what you are able to do to mitigate the problem is a definite advantage. One that will let you sleep a whole lot better at night. And that's exactly why cash flow forecasting is a must-have tool.
Business budgets are powerful tools for small business owners if used properly. Learn how you can use them to spend less and save more in this article.
Knowing exactly where your business cash flow is headed will let you sleep a whole lot better at night. And that's exactly why cash flow forecasts are a must have tool for every small business.
As a business owner you are busy. This definitive guide will show how managerial accounting will get you back to your entrepreneurial dream: creating something you love, helping people in the process, and earning money and free time while doing so.