Fundamentally, there are four ways to increase profitability (without merging with another company). There are no quick fixes. Gradual progress will get you there, but you must focus your strategy and execution on one or two to be successful.
1) Raise prices.
When’s the last time you had a price increase? Most of us are afraid to raises prices because our client may go to the competition. However, clients that come to you on price will also leave on price. More often than not, your clients do business with you because you have differentiated yourself from your competitors for reasons other than price. A 1% price increase can mean a significant change in your bottom line, as we’ll see in a minute.
2) Increase volume.
This means more clients or more revenue per client. However, I would discourage discounting prices to get more volume. I had a client that was recently approached by a client asking for volume discounts. He discovered a1% decrease in pricing meant an 8% decrease in his bottom line. If your clients are asking for a volume discount, don’t be deluded that you can make it up on volume. Often, you can’t.
3) Reduce COGS (cost of goods sold).
If you’ve been doing business with the same material supplier for year, their pencil may not be as sharp now as when they first got your business. I’m not suggesting you shop based on price only, but if you’re not current on competitor’s pricing, you may find you can get as good or better materials or labor for the same or even lower prices.
4) Reduce overhead.
When times are good and the money is flowing, we don’t pay as much attention to overhead as we did during the recession. It’s very easy for overhead to become a larger percentage of revenue than necessary. You and your financial manager should be diligent in looking for ways to cut cost to be more efficient. Trimming the fat every once in a while is healthy for all businesses.
Look for 1% improvements. Here’s why:
$5 million revenue 1% increase in prices or volume is $50,000 each
$3 million COGS 1% decrease in material cost is $30,000
$1.5 million in overhead 1% decrease is $15,000
The total opportunity in this example is $145,000 in profit improvement. The reason for 1% is it’s incremental and certainly attainable. Over time, this can have a huge impact on your business. Pick out where you want to focus your time.
Trying to grow your business and having a hard time? Join the club! Growing your business can be one of the most challenging things you do. If you're having a hard time, here are 5 of the most common barriers to growing your business.
- You've outgrown your money. Sometimes you take too much money out of your business and there's none left for growth. You can certainly borrow up to a point, but when your leverage gets high enough, the bank will say no and you will be left to either borrowing against your accounts receivable (very expensive) or taking on an investor (even more expensive). Calculate your sustainable growth rate (SGR) which is the level you can grow without borrowing. The calculation is ROE x (1-distribution rate). So, if your return on equity (profit/net worth) is 20% and your distribution rate is 50%, your sustainable growth rate is 10% (50% x 20%)
- You've lost momentum. Momentum is defined as force of motion or impetus of human affairs. If you feel your company is stagnant, regaining momentum starts with you, the owner. Start with a little optimism. Your belief will become contagious and will quickly spread throughout the company. Clarify decision making processes. Clear direction is empowering. Finally, if you need to be a little dramatic, give the organization a kick in the pants.
- You've outgrown your management. Growth increases the complexity of your business. If you don't have the appropriate expertise needed in sales, operations or finance, it becomes a barrier to your growth. Here are some signs that management may be struggling: all decisions rely on you, you're feeling stretched too thin, your team is frozen in it's tracks.
- You've outgrown your model. If your current model is not yielding the income you think it should, consider a forward looking forecast to see what changes you might make. To yield results, your operating model must be scalable so you can experience profits at a higher volume. It's critical to have a dashboard with key performance indicators to see how you're company is performing when you scale.
- You're not aligned with your market. If you're not properly aligned with your customer's needs, a gap can open between what a company has promised and the operations required to satisfy them. You achieve market alignment when a business consistently delivers a value proposition in a simple exchange. If you can keep things simple so your company is easy to do business with, you will maintain alignment. However, when growth occurs, it increases complexity and keeping it simple becomes more difficult.
Sometimes we're so busy working in the business, we don't take time to work "on" the business. It's during these times when we step back and gain perspective that we can make the right diagnosis for barriers that exist and then prescribe a solution to re-position the company for growth.
Your business is growing, cash flow is tight and you're wondering when that next big receivable is coming in to cover expenses. Does that sound about right?
In a perfect world, you would have working capital for your business before you get in this situation, not after. Here are three ways to do it.
- Go to your bank and obtain a line of credit through a conventional lending or SBA lending program. Banks provide lines of credit for timing differences between when you collect your AR and when you have to pay expenses. There's typically a 30 day payout requirement. They don't intend the loan to be permanent. SBA can provide a permanent working capital loan through their 7a loan program (amortized over up to 10 years) or through the SBA cap line, a line of credit for up to a 7 year term, (4 years revolving and three years amortizing). Either program may be best for you, but talk to your banker about it or a business advisor if you don't feel like you have a banker.
- Asset based lending. (ABL) Banks loan money to companies based on their balance sheet strength and the cash flow/profits reflected in their income statement. If your balance sheet leverage is above 4-1 and if you were unprofitable last year, you should probably skip the bank step and go directly here. Most of these lenders will charge a 1-1.5% monthly service charge and Prime plus 3 or so for the money. When you annualize this out, your cost of capital could easily be 18-21%. It's expensive, but available.
- Bootstrap your business. Tal to friends and family or an investor. This is the least attractive way to obtain funds. Depleting your personal assets can be risky if you're planning to use those as your rainy day fund. It can be awkward to borrow from family or friends. So, that leaves an investor. It's very difficult to find investment capital from amounts under $500,000 because the investor would rather make a big investment vs a smaller one. The cost of underwriting the investment is the same for both and while the risk is smaller on small investments, so is the reward. Plus, it's not out of the question that the investor may want control of the business, if the investment made is greater than 51% of the business value. That's a non-starter for most owners.
Establishing working capital is a requirement for a solid financial foundation for your business. It's important to understand and meet the requirements for each type of working capital option so you can get the best terms available and make the most of your cash on hand.
If you have a line of credit with your bank, and you take out an equipment loan or mortgage on a building, the bank may cross collateralize your mortgage loan with the line of credit collateral and the line of credit may be cross collateralized with the real estate from the mortgage loan. The second cross is cross defaulted. That means if you have a default on your line of credit then you have a default on your mortgage loan and if you have a default on your mortgage, then you have a default on your line of credit. It doesn't matter if payments are current or not. This is referred to as a double cross.
Here are three things to watch out for:
1) Read the fine print of your commitment letters, loan agreements and promissory notes. Make sure there isn't language in there that provides for this.
2) if this language is in your documents and you want to move one loan or the other, you end up having to move both which creates additional hassle and costs for you. In the case of a mortgage loan, you pay for an appraisal, environment audit and attorney fees/closings again.
3) Watch out for loan covenants, for example a 30 day payout requirement on a line of credit, a cash flow covenant on a mortgage or a leverage covenant on either loan can trigger the cross default on both loans. Loan maturities give the lender the opportunity to insert this language into documents, especially if there's a problem.
I've had multiple clients that had a line of credit and a mortgage loan with the same bank. With this cross collateralized/cross defaulted language in the agreement, if they missed their 30 day payout on the line of credit or they missed their cash flow covenant on the line or mortgage loan, both loans would go into default. Even if payments on both are current. This also locks you in to the bank's terms for both loans which gives them significant leverage on rates and terms.
Many times you don't think to ask the right questions when you're at the loan closing table. Here are a couple to consider:
- Is there any prepayment penalty with this loan?
- Are there any covenants (financial or management)?
- Do I need to do all my banking with you?
- Are my two loans cross collateralized and/or cross defaulted?
Be sure to look for these to be sure the bank doesn't have you tied up without your knowledge.
If you assume the bank is going to renew your line of credit when it matures, you may be in for a rude awakening. Let me share with you a conversation I had with someone.
- The bank approved a line of credit
- The company had a loss.
- The bank reacted to the loss, by renewing the line for only 90 days and said that a new account officer would be assigned.
- They increased rates and fees for the renewal.
These are red flags for business owners to be aware of. The bank was not totally forthcoming about the state of the situation.
- Short renewals (90 days vs 1 year) and an increase in rate signal a change in the bank's point of view on the risk of this loan.
- A change in account officers can be (not always) another red flag.
- The bank renews the line to keep it off the past due list, but a short renewal means that something else is about to happen.
- The change in account officer could signal that the new account officer is in the workout department, (Special Assets) especially since the company lost money last year.
- The change in rate and fees signals a change in the perceived risk on the bank's part.
- It's conceivable that at the end of 90 days, the bank could declare a default at the maturity and enter in to a forbearance agreement rather than liquidate assets.
There are five things you should do prior to your line maturity:
1) Review your commitment letter and loan agreement to be sure you're in compliance with all the terms and conditions.
2) Don't assume the bank will automatically renew. Have a back up plan to repay the bank if they ask for it.
3) Did you have loan covenants? If you did, are you in compliance or can the bank declare a covenant default? (Cash flow and leverage covenants or change of ownership or management are common covenants.)
4) If you are in default, ask the bank to consider a covenant waiver. Yes, banks can waive covenant violations if you have a good reason.
5) If they won't waive a violation, can you offer additional collateral, agree to a lower line of credit amount or provide something of value in exchange for the bank's renewal?
We all know the danger of making assumptions, don't wait for the bank to react to your situation. Either be proactive yourself, or hire someone with the right expertise to help you understand your options.
During this series on Growing Your Business, we’ve talked about Getting the Right People, Getting the Right Strategy and Getting the Right Processes. Our final article is on Getting the Right Execution.
The standards for the right execution are efficiency (doing things right) and effectiveness (doing the right things). Your execution will begin to break down if you’re doing things poorly or doing the wrong things. The financial data that you look at monthly will be an indicator of how things are going.
- I have a client who wants to increase revenue. His revenues for the last 3 years have hovered around $8-9 million.
- He has changed his strategy and has changed his sales process, but his people have struggled to implement.
- Because the sales process has changed, their efficiency has suffered. This is because they’ve been doing it the same way for a long period of time and the old process yielded results.
- In the past, their close rate on business has been about 16%.
- To improve their close rate, their focus is on calling on the right clients with a high likelihood of doing business to increase their effectiveness.
Your execution can focus on any critical numbers on your balance sheet or income statement.
1) If want to have more cash in the bank, focus on being more profitable or collecting faster.
2) If you want to collect faster, focus on days in accounts receivable.
3) If you want to increase sales and profit, focus on revenue, gross or net profit.
4) If you want to reduce debt, focus on accounts or notes payable to banks or others.
All of the above strategies mentioned will require getting the right people involved, and could include process changes. However, the execution or lack of execution will be reflected in the critical numbers on your balance sheet or income statement.
We’ve talked in this series about Growing Your Business- Getting the Right People and Getting the Right Strategy. Today, we’re going to talk about Getting the Right Processes.
Growth always increases the complexity of your business. So, to get the right people, doing the right things right, you need processes in place to maximize your efficiency and effectiveness.
Here are three things you need to know about processes:
1) Process makes a business competitive. Companies with defined processes are better able to evaluate their strengths and weaknesses and identify opportunities for improvement.
2) Process enables growth. By leveraging defined processes, it become easier to deliver new products and services quickly and efficiently. Processes provide a blueprint for new employees and enable cross training to minimize business interruption.
3) Process drives profitability. A company with defined processes can find opportunities to improve efficiency without sacrificing quality and consistency. They can identify duplication of effort and spot areas that are being overlooked.
Here’s a story of how implementing new processes made a huge impact on my client’s profitability. This company was losing money in 2014. They had bootstrapped the company, but now had to borrow money from different sources just to fund payroll. They didn’t know where the losses were coming from.
- Process 1: They hadn’t taken the time to be sure there financial statements were accurate and that revenue and expenses were properly categorized. They established a month end close where part of their closing procedure was verifying that all revenue and expenses were properly categorized so their financials were timely and accurate.
- Process 2: They didn’t have a process to examine what portion of their payroll was converted to billable revenue. So, they didn’t really know how much of their payroll was unprofitable. They created an excel spreadsheet to show monthly payroll and how much of that could be allocated to their contracts.
- Process 3: This Company did not have a process to make sure their completion schedule of their projects matched their billing schedule. They didn’t know if they were over billed or under billed on any of their projects. So, they created a second excel spreadsheet to show what percentage they were complete on each project and then billed accordingly.
The process changes, in this case, yielded a huge change in the profitability and efficiency of the company. They had accurate and timely financial statements to make good business decisions and they cut payroll and increased billing based on the new excel spreadsheets, which in turn dramatically improved profitability.
What process changes have you made or need to make to enable your growth and increase profitability?
Strategy can be difficult to define, but a good starting point might be how we win in the period defined? (month, quarter, year, 3 years etc). Many business owners analyze the past to determine the present and the future. Others look at the market or industry and from that anticipate how they will succeed in the future.
Many of my clients are looking at strategies to address current performance around several areas:
- Increased profits, cash flow or cash
- Growing revenues from existing or new clients
- Collecting accounts receivables faster
- Talent acquisition or talent development
- Outsourcing expertise that is outside your core competencies (IT, legal, accounting, HR)
Sometimes it's hard to focus because you have so many strategies that you can have what I call "paralysis of analysis." I would encourage you to pick your top priorities for the quarter and focus on those. These are five things I would suggest you implement to have success growing your business:
- Pick your top 5 strategic priorities and focus on those.
- Communicate those to your staff so that you have everyone on the same page.
- Measure the success of your strategies by looking at the critical numbers in your financials that pertain to that strategy. For example, look at your AR balance if you're trying to collect faster.
- If you're not seeing results, look at the execution of your strategy to troubleshoot any barriers to success.
- Be sure to celebrate if your strategy is successful for the quarter/year. Everybody loves a celebration!
I have several clients right now that are experiencing good growth, but are having difficulty maintaining their profit margins and sufficient cash to finance their business. If your strategy pertains to growth, be sure to focus on critical numbers like revenue per month/employee, gross profit margin and cash.
How are you doing on your strategic priorities for 2015? I hope this article and others can help you be even more successful than you already are.
I heard a speaker at a conference say that many business owners feel that their most important assets are their clients. However, he disagreed. He stated that our most important assets are our people/employees. Our brand rises and falls on their efforts.
This is not intended to be written from a human resources perspective, but from a financial perspective. If we invest in people, how do we measure our return on dollars spent? Is there a formula for fixed vs variable compensation?
Here are a few things to think about:
1) Watch out for high dollar fixed expense. If you're hiring top talent, and alot of it, make sure, you are getting the proper return. For example, if you just hired a VP of Sales with a $100,000 and you have a 35% gross profit margin. You would have to see an increase of over $285,000 in revenue just to break even on their salary. Watch out that fixed compensation doesn't eat up your profits.
2) For sales people, when possible, implement an element of performance based compensation. Employees love for a large portion of their compensation to be fixed. A business owner would prefer for a large portion to be variable. Why? Because you can tie their compensation to actual performance, revenue or gross profit. The lower the fixed portion, the lower your overhead and the higher their variable piece if they're really good sales. If they're not, they won't last long.
3) Everyone has their own metrics or measurements on return on people investment. When possible, I really try to shoot for a 20-30% return (I call it return on spending)on compensation dollars spent. For example, if I hire a controller and pay them a salary of $50,000, I would hope there would be ways I could see a $60-65,000 improvement in business (efficiency, faster collections, taking discounts etc.)
I think one the biggest challenges most business owners have right now is finding the right people for their organization. Make sure you're doing things to attract top talent to your organization and continue to invest in their future.
Part 1- Cash Flow
Part 2- Establish Working Capital
Part 3- Growing Your Business
When should you sell your business? First, the business and the owner(s) should be ready. There’s a common phenomenon called the rolling 10-year which is the business owner’s time horizon for a sale. What that the means is if you asked the business owner five years ago, today or five years from now, the answer would always be 10 years. You only sell your business once, so it's essential to prepare for it.
Here are five things to consider when you sell your business:
- Get agreement with yourself or your partner on your timetable and business value at exit.
- Do you have a leadership team that can run the business while you’re out for an extended period of time?
- Are there financial statements available that are timely and accurate (possibly audited)?
- Do you have projections that are aligned with your exit plans?
- Do you prepare annual budgets and have historical record of your performance against those budgets?
I’m ready to sell what’s next?
- Determine the minimum sales price you’re willing to accept. You may need to live off these proceeds for life, so get professional help when determining this.
- What’s the fair market value for your business? It’s likely the EBITDA (cash flow) x a multiple (probably between 3 and 5). So, if your cash flow is $300,000, then the fair market value could be between $900,000 and $1.5 million.
- Try to reduce the perceived risk in purchasing your business (experienced management team with incentives tied to a sale, audited financials etc.)
- When the fair market value exceeds the minimum sales price bring in your deal team (M&A attorney, CPA, investment banker and wealth management advisor).
- Two things to keep in mind, sell when the market is hot and sell high when you’re having fun.
You remember the old adage; failing to plan is planning to fail. You only exit once so do the proper planning to get you and the business ready for sale and have some realistic expectations about time horizon and the sales price.
This concludes our four-part series on "Making Your Company a Financial Success." If you haven't already read the other three parts of this series, you can find them linked below.
Part 1- Cash Flow
Part 2- Establish Working Capital
Part 3- Growing Your Business