IT TAKES 10 MINUTES TO LEARN THE FINANCIAL BLUEPRINT OF A HIGHLY SUCCESSFUL, SUSTAINABLE COMPANY
Are you making management decisions with the numbers, or winging it?
I failed accounting. Now, having coached thousands of business leaders over 22 years, I understand that business owners have streetfighter modes and methods that never would have passed the accounting class. Today, with firsthand experience down in the trenches with them, running their businesses by the numbers is actually quite simple… And it is learnable in ten minutes!
There are four types of money in your business: sales, profit, cash, and equity.
Your revenue is your sales. The purpose of sales is to produce earnings (employees convert sales and produce service). As you subtract variable and fixed costs, you calculate gross profit first, then net profit by subtracting overhead.
Sales – cost of goods sold = gross profit
Gross profit – overhead = net profit
Just because your earnings have a dollar sign in front of them does not mean they are cash. Profits have nothing to do with cash. Profits are a theory, cash is a fact. Use cash to pay expenses (operating cash), not profit (retained earnings).
Equity is the total value of what your company is worth if you sell it to another owner. Equity is the total asset value. The biggest asset you have is your employees. The purpose of assets is to produce sales (employees, assets, etc).
Assets → Sales → Profits → Cash Flow
Be effective at acquiring assets that maximize sales, then be efficient at converting those sales into earnings, and then be productive at converting earnings into cash flow.
Not all cash is created equal. There are three kinds: operating, investing, and financing… Three different places cash can be generated. Investing cash is generated by selling property, equipment assets. Financing cash comes from borrowing money. Operating cash comes from sales.
If your business is healthy, your operating cash flow should be bigger than your earnings. No business can sustain without converting profits into cash flow.
You don’t want assets growing faster than your sales. If this happens, your assets are becoming less effective. You don’t want your sales growing faster than your earnings. If this happens, your sales are becoming less efficient. You don’t want your earnings growing faster than your operating cash flow. If this happens, your earnings are becoming less productive.
You want to cascade your percentage growth so your operating cash is growing faster than earnings, earnings are growing faster than sales, and sales are growing faster than assets.
At the end of the day, you want to maximize the monetary assets required to produce the max amount of sales. Once you have sales, minimize expenses to maximize profits. Finally, you want to maximize the cash that profits produce. Assets to sales to profits to cash.
Your business has three bottom lines, not one. The winner always knows the score. The big idea here is to keep score month over month on the following ratios and analyze the trending.
- Effectiveness of your assets (sales/assets)
- Efficiency of your sales (profits/sales)
- Productivity of your profits (operating cash flow/profits)
- How effective is management at acquiring the assets and converting them into sales?
Sales/Assets = Effectiveness %
- Increase sales without increasing assets
- If you increase assets by a small number, could you jump to a much higher sales number?
- How efficient is management at converting sales into profits? How good are you at controlling your expenses? How well are you running your biz?
Profits/Sales = Efficiency %
- Don’t ramp up sales and ignore expenses when you’re seeing signs of success – success teaches you this bad lesson
- Make the assets you have more effective at producing sales, and make the sales you have more efficient at producing profits
- When both of these work in tandem, you increase the odds of creating a sustainable business
- Multiply how effective and how efficient you are.
Sales/Assets x Profits/Sales = Profits/Assets = Return on Assets
- You’re striving to convert assets into profits, but profits are a theory and cannot be spent, only operating cash can be
- Your ultimate goal is to convert your profits (or earnings) into operating cash flow, which is how productive your profits are at producing cash
- Formula for measuring productivity:
Operating Cash Flow/Profits = Productivity %
- You want this % to increase month over month, year to year
- Your monthly financial performance review should consider all three ratios: effectiveness, efficiency, and productivity
- Let’s multiply all three:
Sales/Assets x Profits/Sales x Operating Cash flow/Profits = Operating Cash Flow/Assets
- Your job is to maximize your OCF (operating cash flow) and minimize the amount of assets it takes to do it
- If you have the “pump factor” and your assets creep up, you’ll harm this ratio
- If your expenses are mismanaged or ignored, your profits diminish
- To the extent your OCF is compromised, your ARs (or APs) go up, you’ll erode this formula
Monthly Financial Review Questions:
- How does your effectiveness, efficiency, and productivity compare over 6-8 months?
- Is there a way to increase sales on the same amount of assets, or reduce assets and do the same sales?
- Are assets and sales effectively and efficiently producing the maximum amount of profits?
- Is there a way to increase profits by decreasing expenses or waste?
- Are assets, sales, and profits productively producing the maximum amount of operating cash flow?
- Are each of these relationships improving?
- How can you improve these ratios?
Measure and think about your answers. These are the two biggest points of leverage you have.
To win the game of financial success, cash flow (on a percentage basis) must grow faster than earnings, earnings (on a percentage basis) must grow faster than sales, and sales (on a percentage basis) must grow faster than assets.
As you trend these over 6 months, you begin to see statistics in your business that you can live by. Each is a progression (not to be seen as an error) to make strategic decisions and determine what to adjust to bring your business toward the outcomes that matter most to you and your leadership team.