LLM Book Knowledgebase

Simple Numbers, Straight Talk, Big Profits!: 4 Keys to Unlock Your Business Potential

31 min read

Simple Numbers, Straight Talk, Big Profits!: 4 Keys to Unlock Your Business Potential

Metadata

Highlights & Notes

You get paid a salary for what you do, and you get a return on what you own.

Your business’s number one key performance indicator is this: How big a check did you write to the IRS this year? If you’re my client and I’ve done my job, I can show you how much more money you made even though you paid taxes. I have clients who paid 2 million. A million-dollar tax bill is no fun, but these clients created true wealth that could be traced to real money in the bank.

Don’t focus so hard on not paying taxes. Focus instead on increasing your profits.

If you’re not able to pay yourself a market-based wage so you can see the true metrics of your business, you’re operating at a loss. You can’t let this phase go on too long because you will eventually face two bad scenarios: a below-market wage and no return on your investment. You need to devise a plan that will deliver you a market-based salary and a good return on your investment.

If I hire an employee at below-market rate, market forces dictate that I’m not going to keep that person forever, and replacement will be more costly in the long run than hiring that employee at the market rate. A high turnover rate is very, very expensive. It also makes it hard to create consistency in the workplace, which can lower productivity, service quality, and customer satisfaction (this is also expensive).

The CEO should usually be the highest paid salaried employee in the business. There are only two positions that might get a higher salary than the CEO. One is a salesperson who’s on an eat-what-you-kill incentive program. The other is an expert technical person who gets a high salary at the early stage of the business when you have to build the whole business off of that person’s technical skill set. You might give the technical expert some ownership just for the sake of it, but you’re really leveraging that person’s technical ability with your ability to be an entrepreneur. When you have just one technical person who is an expert (and not the CEO) the business is not vibrant enough to pay the CEO more than the expert. Once you have multiple experts on staff and support people, the CEO has a much larger enterprise and can justify the largest salary.

Keep your goal in mind: You don’t want your numbers to lie to you. Inaccurate numbers will distort your financial information and cause other problems as well.

But let’s face it. Unless you’re building a twenty-year production plant that is going to last fifty years, depreciation is a real cost. If you buy a truck for $50,000 and it wears out in five years, you’ll have to replace it. That’s a real cost. Amortization is just a fancy term that spreads the cost of nonequipment over years just like depreciation, but very few entrepreneurs deal with amortized costs that are significant.

revenue is for show, and profit is for dough. I couldn’t care less how much revenue you have. It’s an important number in terms of cash turnover, but we need to focus primarily on your gross profit before we can fix your pretax profit. Gross profit is revenue less cost of goods sold.

Gross profit minus your direct labor is then what I refer to as your contribution margin before you pay for your general operating expenses.

Don’t think of subcontractors as your labor that you make money from. If I hire a subcontractor, I have to leave profit in the equation for the subcontractor’s business since I am offloading my downtime risk to the subcontractor. Therefore, I am just passing through some of my revenue to the subcontractor.

Your gross profit matters most, followed by how you get to pretax profit.

The standard definition is when the business has income that equals its expenses. At my firm, we discovered that the breakeven concept is a flawed way of thinking. By the time you’re at the breakeven point, your business is already dead.

5 percent or less of pretax profit means your business is on life support. 10 percent of pretax profit means you have a good business. 15 percent or more of pretax profit means you have a great business.

What happens at a million dollars is that you can no longer take care of all the functional positions. You need enough revenue to cover the costs of paying market wages for people to perform in all of your business’s functional positions. If you can’t cover these costs with your million dollars in revenue, you are not making a profit, and you will quickly go out of business.

One of the things I do when I sit down with owners of million-dollar businesses is ask them to put the responsible person’s name beside these eight functional areas: CEO: In most cases, the CEO is the owner, but you may want to hire one if you are not the best fit. Sales: Sales management is the key function, more so than who actually does the selling. Marketing: I make a distinct differentiation between sales and marketing; they are two different functional areas. The same person may be doing both jobs, but they’re not the same job. Operations: This is the person who makes sure that the trains run on time and that whatever product or service you’re selling gets delivered. IT and technology development: You need somebody to take care of information technology capabilities. These days, everybody needs some IT in their cupboard. You might outsource it, but somebody needs to own that function. Finance: Somebody has to pay the bills, balance the checkbook, and do basic financial reporting. You can outsource part of it, but someone in the company has to be responsible for it. Customer service: Who’s the customer service advocate? There is an overlap between sales and operations in meeting your customer expectations. Someone needs to bridge these two areas to make sure the customer is getting what you say you are selling. HR functions: There are paperwork functions in human resources that need to be handled, but as you get larger, someone has to make sure the company mission and values connects with the employees. This has to be tied into the development of your culture and your appraisal processes.

Between 5 million in revenue is what I refer to as the black hole. This is the time in your business growth when you’re forced to add staffing and infrastructure before you can really afford to. Even if you try to add it as late as possible and maybe even pay for only part-time help, at the end of the day you’re going to drive profitability down and risk destroying your business.

As you grow from 5 million in revenue, you are going to hit some badlands, and you are going to need some resources. The most important resource you will need is extra manpower. It doesn’t matter what business you’re in. You have to take care of those eight functional areas no matter what size your business is.

To get through these challenges, you need to prepare your wagon train and have the right provisions. That means you have to hire people with the right skill sets to make the journey with you, and you have to pay them a market-based wage. If you don’t, you’re not going to get through the Badlands in one piece.

When you’re at a million dollars and you start adding the people you need, you feel really happy about it. You’re building a growing business, and you think that anybody you hire will work for you forever. Then you realize at some point, gee, maybe that person isn’t the best fit. You have to understand that people are going to change and that one of the keys to success is continually upgrading your staff.

The need to add management infrastructure seems to naturally occur when you have about twenty employees typically, when you’re between 3.5 million in revenue.

It’s really expensive to hire the wrong people and then replace them. The more times you have to repeat that hiring cycle, the more expensive and more damaging it becomes. The real cost varies, depending on the situation. The usual scenario is that you add labor cost, and the added labor does not increase revenue. Thus, the cost of the additional labor causes an equal drop in net income. Your existing staff see this impact (whether you share numbers or not) and become afraid that they may be let go as the company struggles. Your most capable employees sense this and leave for better opportunities, leaving you with the least productive people. Your lost profit from your hiring mistake leaves you with no excess capital or borrowing capacity to hire a replacement. So you retrench and you assume the role you tried to hire for. You push to stabilize the company so you can make another hiring attempt as soon as you can.

Here’s what I always tell people: hire slowly, fire quickly. I’m a big fan of the topgrading concept of hiring when it comes to interviewing and selecting candidates.

I have tried many different profiles, but I prefer the Caliper Profile from Caliper Human Strategies (www.calipercorp.com).

Another successful approach is hiring young talent and investing in their education. In fact, at my firm we like to hire people straight out of college. They don’t know a lot about anything when they come out of college, but they also do not have any baggage to unlearn. I like having the responsibility to fill their heads full of things I want them to know. A lot of my clients have had their greatest success with young talent who bought into the vision and the dream for the company. These young people are like sponges, and they want to absorb knowledge and information.

Even though we know we have to hire the right people, we still say we want to add those labor costs at the last possible moment. Although you don’t want to add the cost of new employees until you have to, you also have to take your time to find the right people and hire them before your business outgrows your ability to manage all the functional areas by yourself.

Calculate how much cash you need to hire the people you need, then estimate how long it will be before your business can pay the new hires and still remain profitable.

I’ve had other clients who took the investment money and never tapped into it. They put it on their balance sheet and kept on going. This money was their true capital safety net, which is a great strategy. These clients were committed to being profitable every step of the way from the very beginning of the business. They also had reserves in case they hit unexpected obstacles. That’s another key to success.

You need to reinvest in your business during the 5 million phase, but that doesn’t mean you shouldn’t make a profit during this time. It simply means you leave the profits in your business to fund the growth rather than relying on debt or investors. That’s the whole strategy behind paying yourself a market-based wage. You need to live off your wage instead of living off the profits from your business.

If you don’t have the provisions you need (a capital safety net) and you’ve already started the hiring process, you might find that you have to downsize to fix your business model and get profitable and healthy again.

The teams that win are the teams that get the most productivity for every dollar of labor.

Focus on your gross profit per labor dollar as your key indicator for labor productivity.

Equity is your assets (what you own) minus your liabilities (what you owe).

They made the classic mistake of adding labor to support their growth, but they failed to get enough of an increase in gross profit to drive toward profitability.

Notice that there is a flat year from Year 2 to Year 3. When businesses have early success, they sometimes think they have reached a pinnacle and believe they’re as big as they’re ever going to get, so they just put their head down and stop thinking about growth. Notice that Company B’s pretax profit goes down between Year 2 and Year 3. This is because they hired more people to relieve some of the pressure created by the growth of the business.

Realistically, to have proper labor efficiency you have to make sure that the annoying tasks are distributed to everybody in the company. Labor creep is one of the most common ailments I see. It causes a lot of black hole struggles.

How did Company B remain profitable every year? They did not add labor until the last possible moment, and the owners, along with their management responsibilities, were still productive in the business.

A key talent is to know what tasks to reassign to new hires and what tasks to assign to your current employees.

You won’t own the contacts, and that’s a really dangerous thing. Unless you have a fear of sales, don’t outsource the sales function.

Costs that stay essentially the same regardless of sales volume are referred to as fixed costs. If you sell goods, your nonsalary costs include the cost of goods sold for the products you sell. You can predict that number because you know what you have to buy. These costs will vary based on sales volume, so they are referred to as variable costs. There are also step-variable costs. That means you have to add the cost before you can fully use the cost you are adding.

If you try to raise your salary cap when you have only 10 percent pretax profit, you’ll drive your profit down toward 5 percent, which is the danger area. When I do a salary cap computation for a client, I bracket it with a minimum acceptable target and the maximum target, and I make sure their salary cap runs between those two numbers.

In these examples, you can see that you need to hit at least 10 percent pretax, so that 1 million in revenue. This is why profit matters. Everybody is going to dig that cash deficit hole in the beginning. It’s just a matter of how fast you can get out of it. There are really only three ways to remedy the cash deficit hole: You can cover it with debt, but you have to use after-tax profits to pay it back. You can cover it with sweat equity instead of getting your market-based wage. But how long can you live with or accept less than a market-based wage? You can get an outside investor, but you have to either repay the investor with after-tax profits or have a good story to persuade the investor that your zero-profit business is worth a lot of money.

Cash is the most powerful opportunity magnet ever created.

The four forces of cash flow are as follows, in this order: Paying your taxes Repaying debt Reaching your core capital target (building working capital) Taking profit distributions

Your core capital target is simply this: two months of operating expenses in cash and nothing drawn on a line of credit.

For clarity, let’s define distributions as a draw against the equity of the business. Entrepreneurs make these distribution payments in a number of different ways.

Your operating cash flow starts with your net income for the month; then you add back the difference in the changes in accounts receivable, accounts payable, and inventory (if applicable). You can see that there’s a significant disconnect between pretax profit and operating cash flow, and there are big waves in the operating cash flow. This graph looks almost the same in every single business I work with. I’d like to see businesses never go below zero in any one month, but even in my own business, that’s not always practical. We have significant heavy times of the year because of tax filing deadlines and some other project deadlines.

Whenever possible, I recommend cash-basis accounting because there’s a much tighter correlation between the cash in your hands and paying taxes on that cash. There are a few rare circumstances when it’s better to be on the accrual system, such as a business that gets paid up front for something. But that doesn’t happen very often.

In most cases, this is my philosophy: Don’t pay taxes until you absolutely have to without incurring a penalty. Until you pay the taxes, you have to set the money aside and get it out of your financial calculations so you know it isn’t yours to spend.

You can’t build wealth until you get out of debt. And make no mistake, getting out of debt really does help you build wealth.

People who take a low- to no-debt approach can handle bad economic news because they live more stable and productive lives.

For entrepreneurs, credit lines are the equivalent of crack cocaine—it’s that addictive. Why? Because when you draw money on a line of credit, you’ve postponed a hard business decision that should have been made a lot sooner. Sometimes people would rather exhaust their resources than make the hard decisions.

You should rely on debt only in extraordinary circumstances.

Do not confuse debt with capital. Capital is the cash you leave in the business to fund your receivables and inventory for normal business conditions, and debt is financing for special cases. Once you start financing normal receivables with debt, you are lowering the odds of your business being able to survive a downturn.

An unusual disruption doesn’t mean you’re not profitable anymore. It’s a situation where there’s an unexpected delay and you’re reasonably sure the cash will show up in the future.

Recall from our earlier discussion that your core capital target is two months of operating expenses in cash and nothing drawn on a line of credit.

By default, your core capital target forces you to pay for accounts receivable, inventory, and equipment with capital or term debt. Your target isn’t based on equity, because that number might be high for reasons not related to cash. For instance, you might have a high requirement for fixed assets. So keep it simple. You need to be current with paying all your vendors and reasonably current with collecting from all your customers.

Remember, history is the best predictor of the future. You just need to look back and decide if there’s anything you can do to keep that down-stroke happening again. There’s usually nothing you can do to prevent it, but what you can do differently next time is have cash available to cover the downstroke. This way, you can fund that deepest downstroke instead of drawing on your credit line to cover it.

Businesses that have cash and no debt attract magical things. The opportunities that fall into their laps are just amazing. One of my former partners had a client who was in the building supply business. The client was an old-timer who never had any debt and always had over a million dollars in the bank. We were talking to him one day and he said, “I love a recession!” We were stunned. He continued, “I love a recession because I’ve got cash and I can buy stuff cheaper than anybody because they know that I can pay it. I can work the deals while all my competitors go out of business. I’m the only game in town because I saved my money and they didn’t.”

Capital formation is the sum of sweat equity, money you invest, and after-tax profits that you keep in the business. When you want to take your money out, there’s not a specific number because you don’t have an exact amount attached to sweat equity. Capital knows no parent once it comingles with the rest of your business dollars. It’s all just capital. Sometimes people think if they put 100,000 back out when the company’s running smoothly. That’s a fallacy. You still need your core capital target.

Consistent profits over time allow you to build equity by keeping those profits in the business, which then allows you to hit your core capital target, which then allows you to have excess cash that you can take out without damaging your business’s ability to grow or deal with struggles.

Most entrepreneurs who have businesses between 5 million need to build up about 2 million, you can set your sights even higher. Build a solid foundation first, and then you can enjoy taking some risks.

The cash-basis method is a very valuable approach. It’s the best methodology to reflect when the cash shows up as well as when it doesn’t. The only time you wouldn’t want to use a cash basis is when you consistently get paid before you have to pay your vendors, which is rare.

Realistically, you should be paying last year’s taxes with the tax funds you set aside last year. Even if that year is a bad year, those tax payments are being made with cash that was already set aside for the purpose, so it’s okay.

In a perfect scenario, you should pay yourself a market-based wage for what you do. Then withhold taxes from that wage as if the business is going to make zero profits. The goal is to be able to take your salary, pay your taxes on your salary, and live off the net amount. Base your lifestyle on the net amount, and you won’t have to rely on distributions to pay your personal bills.

If the business makes a profit beyond your salary, the business should make a tax distribution to cover the taxes it caused you to pay.

After the tax distributions have been made, you can take profit distributions. Use them to build your emergency fund and repay your personal debt until it’s gone. After that, you can start investing and building true wealth.

Opportunity is missed by most people because it is dressed in overalls and looks like work. —Thomas Edison

  • tremendo quote. 100% cierto

I’ll use my company as an example. I have to get 1.00 I spend on labor to reach my profitability target, regardless of whether that $1.00 is paid to an administrative person or a production person.

In every business, each dollar spent on labor has to show a demonstrable output for gross profit. Here’s a simple metric to keep in mind: If you aren’t at 10 percent pretax profit, use what you learned about managing and raising your salary cap in chapter 3 to determine how much labor you need to cut or how much gross profit you need to add to get to that number, and then try not to add staff until you get to 15 percent pretax profit. This is how you control internal growth and profitability.

Every business has a culture, and it’s an important part of the foundation of your business. Your challenge is to find a way for your culture and profitability to play nice with each other.

It’s a good idea to document your culture and how it ties into your profitability as a business because the more you document it, the easier it is to live it and maintain it.

Owners commonly want to have a family atmosphere. This is admirable, but understand that a company with a great culture and no profits is going to die. You have to make sure your culture doesn’t excuse people from getting their jobs done. There’s an economic relationship between productivity and the amount you’re paying people to get things done. If this relationship isn’t balanced, you have a flawed business model.

Essentially, your goal is to avoid overpaying or underpaying your employees. Both situations are bad, but the entrepreneurs who underpay employees tend to have companies that struggle in the long run due to high employee turnover. Companies in the same industry that pay higher wages and have fewer employees might be more profitable than companies that pay lower wages and have more employees, but it’s a very delicate balance. You can’t assume that if you pay higher wages you’ll get more productivity, and you can’t assume that if you pay lower wages you’ll get the same productivity.

Never give an employee a cost-of-living adjustment. If you do, you will have many employees asking for a salary increase based on what they need to make a living. The amount they choose to spend in their lives is not your problem. What you pay them should be within a market-based range for their roles.

Employees often end up being underpaid because they came into the company at entry-level positions. Even though you inch their pay up every year, you suddenly realize you’re adding new people who are making the same amount as employees who came into the business two years earlier. Now you have employees who have been there for two years and are making an entry-level wage. You must decide if those people are underpaid and worthy of a higher salary.

Be careful about hiring people for 80,000 a year. You need to have a career path that gets them back up to 80,000 job back. You often have to consider these transitional people to be short-term employees.

My firm has administrative positions, entry-level accounting positions, client manager positions, and specialist positions. Salary ranges are established for each position, and they take into account the required skill sets and education. For production positions, we look at the productivity needed based on the revenue and gross profit requirements. Not every business can tie profitability or gross profit or revenue on a per-employee basis, but many can. If you have that ability and there’s software that allows you to capture the data, it’s one of the best ways to understand and evaluate employees.

I focus on career planning and career path in employee reviews. Realistically, my goal is to invest in my employees’ careers for as long as they want to be at my firm. We discuss their career goals and answer a few questions. Do they require additional education? Do they need different skill sets to get promoted to a higher level? The more closely you define and help develop an individual’s career, the more likely you are going to have a long-term employee. Even if an employee’s desire goes beyond working at my company, it’s still in my best interest to help the employee develop so that person can have a successful career. As long as the employee works for me and I’m getting productivity for the money I’m paying in salaries, that’s a good thing. I want my employees to understand that they are welcome to work in my company as long as we are both getting a fair exchange.

It’s my responsibility as the CEO of the company to provide my employees with a vibrant environment, a fair wage, and a good culture. When there’s a point where it doesn’t work anymore, I’ll help an employee transition into a new job.

But if we try to help each other become the best we can be, it leads to a much better cultural experience for everybody. You’ll even find that some people stay far longer than they otherwise would have.

Focus on the top three to five skill sets that are required to maximize productivity for each job.

I tell my staff that their pay changes for only one of two reasons: if the salary economy changed and we adjusted the pay scale or if they moved up a level.

When the latter happens, I say something like, “You’ve moved from level two to level three to become a client manager.” The employee knows that the pay scale moves up by a certain amount. I make it clear what the person will do differently as a level-three client manager, and I explain what the employee needs to improve on to get to level four. By doing this, I can give people definitive guidance and provide a focus to their career paths.

Have a Fallback Plan In The Great Game of Business, Jack Stack looks at smaller incentive plans that were adapted to meet current market challenges. If you adapt a plan to consider the market, you need to have a fallback option in case the market forces make it impossible for employees to meet the incentives. My fallback plan is to use discretionary judgment on what the target incentives should be for people who went above and beyond the call of duty but just didn’t get results. Obviously, I can’t give out incentives that my business can’t afford. If the market prevented the employee from hitting the target, I have to use my judgment to determine what the payout should be. If the employee just didn’t deliver, I have to allow the failure and decide if it’s a one-time thing or if the employee needs to be transitioned into a new role or maybe even out of the company.

You can invest in a company by buying its stock, and you should expect a return on your investment. You should expect to get dividends with a nice rate of return, or you expect that the business will be sold and your investment will be worth much more than it was when you purchased the stock. When other people invest in your business, they expect the same returns on their investments.

You should keep all this in mind when you decide how you’ll obtain capital. You have three choices: your own money, other people’s money, and sweat equity. Each one has its price. Choose wisely and know the reasons for your choice.

If you start a business with your own money, you’re going to defend it to the greatest degree. It’s unlike anything else because you’re the most frugal when it is your own money. You had to work hard to get it, so you’re going to be careful with it. I’ve seen people inherit money and totally blow it. That money wasn’t earned, and that’s the difference. When people invest money they earned, it’s very precious and they’re careful with it.

When you capitalize your business with your own money, you want a good return on your investment. You can calculate it by dividing your pretax profit by your equity. As you know, my philosophy is that your business should make somewhere between 10 and 15 percent pretax profit. That rate of profitability coupled with maintaining a core capital target of two months of operating expenses with nothing drawn on a line of credit works out to about a 40 to 50 percent rate of return on the investment that you have in the business. When you get beyond 15 percent profitability, the return goes up to about 60 to 70 percent.

Employees who become shareholders should be motivated first and foremost by the desire to get a return on their investment.

If you’re going to look at a report frequently, it needs to show a very small amount of data. If you’re going to look at it infrequently, it can contain more data.

The report has to be easy to read and digest; otherwise it won’t be useful.

Daily report: Cash balance Weekly reports: Cash flow forecast; sales and productivity Monthly reports: Profit and loss; balance sheet and where the cash goes

An example of a cash balance report is shown in exhibit 8.1. It is important to note that this report needs to be simple and easy to e-mail and read on a PDA or smart phone without opening an attachment.

The purpose of the cash flow forecast report is to make sure you have money in the bank when your bills are due. It shows a two-week projection of your expected sources of inflows and outflows. Break your payables up into these five key categories: General bills Payroll Payroll taxes and benefits Rent Payments for debt (lines of credit and fixed-term notes)

A few of my clients tried to expand the projection beyond two weeks with limited success. This report is designed to give you a two-week heads-up about your cash flow.

A profit and loss report (P&L) shows you if your business made or lost money during the reporting period. It shows your revenue, costs, and expenses, and it concludes with your net income. You just have to keep in mind that a month is an extremely inaccurate period of time. I’d never look at just one month by itself; I’d look at a minimum of six months of monthly data to see what the ups and downs were. The most useful presentation of the P&L for me is a rolling-twelve view.

Budget between 2 and 5 percent for marketing, but continually monitor if it’s working and if you’re getting value from the marketing. Get a better grasp on how to strategically spend the dollars.

The simple rule of accounting is this: If your balance sheet is right at the beginning of a period and it’s right at the end of the period, then the net income number has to be right. It’s a closed system; it has to work. So if you find an error, don’t continue to explain it month after month. If inventory is misstated, fix it. If there’s a receivable on the books that you’re not going to collect, write it off.

My experience has shown that the economic value of a business is typically based on the last three years of pretax profit plus the equity (assets minus liabilities) in a business. This method is a blend of the earning capacity of a business and the capitalization of the business. I have found that deals rarely get done at lower value than this, and many times a total sale of the business will yield a higher number because the seller now has a better understanding of what the business is worth whether sold or not.

There are five basic elements that combine to drive the profits that are used to establish the value of your business: customers, employees, processes and know-how, core capital, and intellectual property. These elements are the essential drivers of your business because without customers, you have no sales or gross profit. Without employees, you have no one to execute the business strategy. If you have flawed processes, you either can’t serve your customers or you’ll have excess cost and lower profitability. Core capital gives you the financial resources to fund new activity and balance the ups and downs of the business cycle. Intellectual property can give you a competitive advantage and drive your business to an above-average profitability and protect market share.

“You know, it’s funny. We always make money on the spreadsheet, but at the end of the year it’s not in the bank account.”

A budget is a license to spend; a forecast is your road map to profitability.

Budgeting is one of those things that can make you keep your head down when you actually need to keep your head up to see what’s coming at you. Instead, spend 25 percent of your effort looking at what has happened and 75 percent of your effort looking at numbers and thinking about what you want to make happen.

It’s one of those times where growth actually used cash. You need to understand that when it comes to cash flow, a rise in accounts receivable uses cash.

Hope is not a strategy.

When the dashboard is complete, we can answer questions like: Where do you stand on profitability? How close are you to your sales targets? What are your operating expenses? How do you fare on your salary cap? How are your collections or DSO and receivables? Where are you in regard to your core capital target? Do you understand the tax implications of the profit?

Backlinks