Your Key Performance Indicators & How You Measure Business Success

It’s ironic that after years of a struggling economy and firms doing whatever they can to survive, a big threat lies in the signs of recovery.

That’s because growth can cause financial problems.

It’s another reminder of the adage:

Turnover is vanity, profit is sanity but cash is reality.

As A Business Shrinks, Working Capital Was Released Back Into Cash

When businesses traded as the economy went into recession, profit reduced and some may have even slipped into the red before overheads could be trimmed back.

However, it’s likely that they received a cash boost which more than compensated for the loss at the bottom of the Profit and Loss Account.

Working capital is normally defined as:

• Stock and work in progress (or inventories); plus
• Debtors (accounts receivable) and payments in advance; minus
• Creditors (accounts payable) and other obligations to pay in the future

The way money flows across these elements in the balance sheet is known as the working capital cycle. Money invested in working capital increases as the business grows and reduces as sales revenue declines.

Provided stock turn (inventory turnover), debtor days (days sales outstanding) and creditor days (days purchases outstanding) remain consistent, the change in working capital is inevitable.

This may have been an unrecognised benefit of the hard times.

The problem will become very clear if the economy picks up and carries businesses with it.

If you’re a service business and you sell person hours rather than products, it’s likely you will have some kind of work in progress that can grow quickly as business grows.

This represents work down for clients but not yet invoiced. Because your main cost is labour, your potential cash problems may be even worse than for a stock business. You don’t have the benefit of delayed payment terms as your employees need to be paid each week or month.

As The Business Grows, Working Capital Increases

Depending on your terms of trade, you know that if you sell this month, you won’t get paid for two, three or four months time.

That timing difference between goods going out of your stock and money flowing into the bank causes problems.

If you think the increase in demand is going to continue and not be a one-off, you will want to replace what you’ve sold and increase your stock.

You will buy more.

This is the systemic effect of changes in demand that ripples through the supply chain and unfortunately amplifies the effect.

If you’re not familiar with this effect, please read

The Beer Game: Systems Thinking When Systems Bite Back

This can over-exaggerate the growth which causes demand to be stopped dead in its tracks as customers realise they are seriously over-stocked.

Is The Cash Problem Industry-Wide Or Company Specific?

If everyone is experiencing growth, then the problem is likely to be widespread.

The impact on individual companies depends on:

• The length of their own working capital cycle. The shorter the better.
• Their relative profitability. Profit will eventually put money into the bank so businesses with higher profit margins will have less of a problem than the lower profitability businesses.

Both factors can be measured in relation to sales revenue:

• Working capital to sales %
• Profit before tax to sales %

If growth isn’t spread throughout the industry, the individual business still risks the same growth in working capital and cash crisis. There is also the risk of price wars which carries very different risks to long term profitability.

In fast growing businesses, this shortage of working capital is known as over-trading and has caused many seemingly successful businesses to suddenly collapse into bankruptcy.

What Can Be Done To Manage The Cash Problem Of Business Growth

The first suggestion won’t surprise you.

Do a cash flow forecast and update it regularly.

Importance Of Cash & Cash Flow Forecasts

Look for ways to reduce your working capital cycle.

• Can you reduce the stock to sales revenue?

• Can you collect your debtors (accounts receivable) faster?

• Can you negotiate delayed payments to your suppliers (accounts payable)?

The first sign of an increase in demand from your customers might not seem to be the appropriate time to squeeze their credit terms. In fact, you might be tempted to do the opposite and agree to their request for extended terms.

Be careful.

Just as an upturn in business can put your cash flow under pressure, so it can with your customers.

There will be plenty of businesses who survived the recession but can’t survive the upturn when it comes.

My advice is to credit check every customer whose non-payment would cause you the slightest difficulty.

It’s not infallible but it gives you information to make decisions.

Stick to credit limits and combined with your agreed credit terms, actively manage your customers’ debts. If necessary, take action on overdue debts.

If you try to sneak extra credit from your suppliers by delaying their payments, I recommend that you monitor this creditor stretch. Your bank balance and cash flow forecast are no longer showing the underlying position.

If creditors suddenly tighten up (as they hit their own cash crisis) or even go bust and you have to find a new supplier who holds you rigidly to agreed terms, your cash management can change dramatically.

Look at your stock / inventory levels and make cautious decisions about increasing minimum and maximum stock levels. These should be based on the lead times for supply and the variability of demand.

It might be worth paying a small premium in price to buy from a company who can delivery the next day rather than in four weeks time for some proportion of your supplies.

The last issue to consider is the profitability of the growth.

Again, at the first hint of a big order after lean times, it can be very tempting to offer a big discount to make sure you get it rather than your competitors.

Talk it through with your management team. Pay particular attention to the margin you’ll be left with. Is the prize worth a few cash management problems? How will competitors and other customers react if they discover this low price offer?

Low profitability makes the cash problem from growth more likely. Reducing prices from a low profit base can be suicidal.

Remember, turnover is vanity, profit is sanity, cash is reality.

What Do You Think?

Have you experienced the financial problems that come from growth?

What happened? What did you do?

I have recently read the book “Profits Aren’t Everything, They’re the Only Thing” by George Cloutier with Samantha Marshall.

In the review I said the basis message for business owners is “to grow a pair, man up and take control of the profitability of your business.”

It’s not a nice, gentle book that says you will have a profitable business because the law of attraction will say you deserve it. Just the opposite.

I think any business owner who is struggling needs to read it and make their own minds up about what they will and won’t do.

The 15 Profit Rules by George Cloutier

The book is written around the controversial 15 Profit Rules and I thought I’d share them with you.

1 – Profits aren’t everything, they’re the only thing.

2 – End denial.

3 – Forget sweat equity.

4 – Love your business more than your family.

5 – The best family business has one member.

6 – Delegate, don’t abdicate.

7 – Live and die by a real plan.

8 – Pay for performance.

9 – “I am your Work God.”

10 – You are not in business to pay your vendors.

11 – When filing for bankruptcy is your best option, do it early!

12 – Don’t treat sales like your mother-in-law.

13 – Give up golf, retreats, off-sites and trade shows.

14 – Teamwork is vastly overrated.

15 – It’s not the economy stupid, it’s you.

There aren’t any words minced in this book. As I make clear in my review, I don’t agree with everything.

It’s easy to fall into the trap of thinking that business is simple and especially that more sales equals more profits.

Sometimes it’s right but sometimes it’s wrong.

Sometimes growing a business can destroy it.

There are three big reasons:

1. Growth can destroy your brand and market positioning.
2. Growth can cause you to add costs faster than you add extra margin.
3. Growth can cause you to run out of cash.

Let’s look at these three problems in more detail.

Growth Can Destroy Your Brand & Positioning

I blogged about whether Stella Artois are making a mistake by extending their brand to include cider.

It’s a great example of a business with a very clear brand image – Stella is a premium priced lager (light beer) from Belgium. But now after the introduction of Stella Artois Cidre, it’s not. Stella no longer means lager.

And that come mean that sales of the lager go down as sales of cider go up. Or it could mean that Stella lager can no longer command a premium price.

That’s not good news.

But it could get worse.

Lager drinkers and cider drinkers may have very different customer personas and it is tough to appeal to everyone with a well known brand. After all I can’t think of any drinks company that has crossed cider and lager.

When I think of cider I think of Merrydown (my personal favourite), Magniers, Strongbow, Taunton’s etc. When I think of lager I think of Carlsburg, Kronenburg, Carling, Heineken, Fosters and Castlemaine.

This blurring of position is a particular problem where:

1. Prestige is an important reason for buying/owning – personally I think that both Mercedes and BMW have reduced the status of their brands by going into the mass market with the A class and 1 series respectively. I think Toyota got it right when they wanted to move upmarket and created a new brand, Lexus, to do it.
2. Specialisation is important – people of wary of the jack of all trades, master of none and it doesn’t matter whether that’s in professional services, tradesman or your local takeaway restaurant. I’ve just had a flyer come through my door from a  local takeaway offering pizza, kebabs, burgers, fried chicken, fish and chips… but it’s tough doing all those to a good standard when competitors specialise.
3. Where capacity is limited – a shop selling a bit of everything is a useful convenience in a small village or on a housing estate but it lacks a clear reason for being in the city centre.

Growth Can Cause You To Add Costs Faster Than Margin

The easiest way to grow the top line sales numbers is to cut prices and offer customers a better deal.

There are four big problems with this approach.

First, what I call margin deception. This is when you think your gross margin or contribution is growing because sales are increasing but you’re deluding yourself.

The arithmetic of the extra sales required to make up for a price reduction can be alarming if you don’t calculate them in advance.

I’ll just take you through a numbers example.

Imagine you sell 100 units at a price of £1000 and you make a margin of 35% or £350 on each (i.e. costs variable costs are £650) every month.

That’s a margin of £35,000. (100 * 1000 * 35%) on sales of £100,000.

Now imagine you decide that it’s a good idea to reduce prices by 10% because you’re confident that you can get an extra 20% of volume.

And you’re proved right.

Sales volumes go up by 20% to 1,200.

Sales prices fall from £100 to £90.

Total sales are £108,000 – £8,000 higher than before – not as good as you expected because you hadn’t done the maths but it’s still up.

Unfortunately your margin has been battered.

The price reduction has reduced margins from £350 to £250 (that’s the selling price of £900 minus the cost of £650).

1200 units sold at £250 each gives a margin of £30,000.

That’s £5000 down from the original margin of £35,000.

Over 12 months, that’s a £60,000 drop in profit because you hadn’t bothered to check how the numbers work.

The second problems is that price discounting often attracts the wrong type of customers. Low prices are most appreciated by the people who really care about buying at the lowest price, and they have little loyalty. The first sign of a better price, and they are off.

Third, you can’t expect competitors to stand idly by and let you “steal” their customers by offering lowering prices. Your competitors are likely to react and match or even beat your low prices. They will find out and if you are taking much valuable business away from them, they’ll get mad.

And if they match your prices, all you’ve done is cut your profits and theirs. Even worse, you could start a price war.

Fourth, overheads are usually driven by transaction volumes. As you sell more, you need more people to handle the extra orders, to do the despatches and to follow up and collect the cash. You can try and hold the line but extra work creates pressures and it causes things to slip. Perhaps orders are delayed because the paperwork can’t be processed or mistakes are made in picking and packing as staff rush to meet targets. Either way customers get angry.

Growth Can Cause You To Run Out Of Cash

If you manage to avoid the first two ways that growth can kill your business, by staying focused and making sure that growth is profitable, it can still be profitable.

One of the reasons why the business failure statistics in the 2009 recession have not been as bad as you might expect is because a shrinking business generates cash as the working capital in stocks and debtors reduces.

It goes the other way for growing businesses so when the economy picks up, order books get healthier and sales go up, you can expect businesses to run out of cash. And in the current situation, banks don’t appear to be eager to lend.

Growth needs financing unless you’ve got a high margin business which has a favourable working capital cycle. Retail can be good because sales are paid immediately so provided stocks are smaller than creditors, the money to finance the business comes from the suppliers.

But if stocks are high, customers expect good credit periods and suppliers won’t give you credit, your cash flow gets squeezed as the business grows.

It gets even worse if you have to increase your costs in advance to either create the growth (advertising or extra salespeople) or to service the planned growth (extra warehousing).

Growth Can Be Profitable

You can get caught in profitless, cashless growth which damages your market position but growth done the right way can be very profitable.

My advice is to do your planning upfront and challenge your assumptions so you can see what happens if things don’t work out as you hope.

It’s very easy to make growth look good on paper by making over-optimistic assumptions about extra volume and ignoring the likely actions of competitors so do some what-if tests and see where your growth plan is most vulnerable.

The full title of this book by Rob Warlow is

“Loan Sharp: Get the business finance you deserve“.

In my review posted on Amazon.co.uk, I gave the book Five Stars. This means it is Excellent and Very Highly Recommended.

Here is my book review.

The key to your banker’s mind

Loan Sharp is an excellent book from Rob Warlow packed with practical tips on how you can get the business finance you need.

What makes the book so special is that the author takes you into the world of the small business banker so you can see how and why they make the decisions they do. [continue reading…]

I was reading today’s edition of The Sunday Times and the front page lead was “Fat cat row over public sector pay.”

While concern is expressed that the top 300 bosses in the public sector saw their pay jump 12.8% to an average of over £237,000, one man stands out.

That is Adam Crozier, the group chief executive of Royal Mail.

His total salary and benefits package leaped ahead by 21% to £1.25 million.

How Long Does It Take To Earn £1,000?

The Sunday Times has worked out that he can earn £1,000 in just one hour and 27 minutes of sitting at his desk. [continue reading…]

The UK credit crunch in the wake of the sub-prime mortgage loans crisis in the US and the run on the Northern Rock bank has made it more difficult for small businesses to raise loans the Federation for Small Business has reported.
Even if businesses manage to get a loan, it is more expensive with interest rates of 10% to 11% so this is 4 to 5% more than base rates at the moment.

More details on this story.

If you need to raise finance at the moment, or even renew an existing overdraft then you need to make sure that you prepare properly for your meeting with the bank manager.

Talk to your accountant, update your business plan, make sure that your forecasts are realistic and credible.

Getting To Know Me

[sos]

[6Steps]

In this article, I list eight common finance mistakes which could be harming your business.

Are you one of the many small business owners or managers who will admit that finance and accounting are not amongst your strongest skills?

If so, you may find it very worthwhile to check whether you are making any of these common financial mistakes that could be costing you a fortune.

Finance Mistake 1 – Accepting Losses While Building Your Business

It’s conventional wisdom that you will lose money during the early stages of creating a business and that period may last for up to three years.

While it is certainly true that you can have a lot of start-up expenses, you also need to accept that your business is in its infancy and you have to cut your cloth accordingly. [continue reading…]