September 18, 2009 / by Collaboration / in Financial / Legal
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By Michael Gunther
Financials are the foundation for every business, yet they are often the most ignored aspect. Too many business owners do not understand or even employ basic financial principles in their business – some are afraid of what the numbers might tell them and others have never been taught how to manage their business financials.
Okay, I can hear the yawns already. But what if I told you that there are two basic principles to help you better manage your money and grow your business profitability? Would that give you incentive to pay attention to your financials?
Principle #1: Understand your Gross Profit % (aka Gross Margin)
Understanding this number is a vital step toward creating a financially thriving company. Let me provide an example. Say a business generates $100,000 in revenue and they have $65,000 in Cost of Goods/Services Sold (the total cost of delivering a product or service, including commissions, merchant fees, etc.). This means their Gross Profit is $35,000 ($100,000 – $65,000 = $35,000) and their Gross Profit % is 35% ($35,000 / $100,000 = 35%).
So far, so good. Now, let’s show the importance of Gross Profit when making a business decision. Say this business wants to spend $1,000 on a new ad campaign. They just need to increase revenue by $1,000 to cover these costs, right? Not so; based on our example, if they earn $1,000 only 35%, or $350, is Gross Profit and the other 65%, or $650, goes right out the door to deliver the product or service (Cost of Goods/Services Sold). One way to think of it is they have only $35 left for every $100 generated.
To pay for the $1,000 ad campaign, they need to increase revenue by $2,857 ($1,000 / 35%). It’s easy to see that if a business doesn’t understand this principle they can make financial decisions that are hazardous to their business.
Principle #2 – Manage Your Business with a Cash Flow Statement, not a Profit & Loss Statement
Now let’s take a look at why the Cash Flow Statement is so important. Some owners make the big mistake of thinking the Net Profit number on their Profit & Loss Statement is what they have in cash to spend. Once again, this is not so. The typical Profit & Loss Statement does not reflect principal payments you make on any loans you are servicing nor does it reflect any draws that you take instead of salary through a payroll check.
If you look at your Profit & Loss profit position to manage your cash flow (instead of your Cash Flow Statement), you will struggle financially – even when your Profit & Loss Statement states a profit. You’ll be spending cash that you don’t actually have.
Bottom Line
Business owners who understand and apply these two principles have more control over their business financials and business strategies, allowing for better financial decisions and ultimately a profitable, thriving business.
Michael Gunther is Founder and President of Collaboration, LLC, a team of highly skilled business professionals who are dedicated to assisting proactive business owners build profitable, sustainable businesses through results oriented education, coaching and consulting services. Learn more at www.collaboration-llc.com.
