For many small businesses owners wrapped up in the day-to-day of running a business, figuring out their profit and loss (P&L) often becomes a task foisted onto their accountant once or twice a year. But to maintain a healthy business, you need to track revenues and expenses at least quarterly to see that you have enough left over after taxes to pay down debt, reinvest in operations, and build up cash reserves. While margins vary by industry and type of business, without enough free cash flow, your business will find it difficult to survive, never mind grow, if faced with unforeseen costs or loss of revenue.
While a P&L statement can help you understand the day-to-day costs of running your business, a break-even analysis is a better indicator of available cash flow as it breaks out fixed, variable, and debt service costs. “Once you reach that threshold where revenues cover all your expenses, the amount of money you make for every incremental dollar is much higher because your variable expenses aren’t growing as fast as gains on the revenue side,” explains John Matthews, president and CEO of Gray Cat Enterprises, Inc., a strategic planning and marketing firm based in Wake Forest, North Carolina. He recommends calculating multiple “what if” scenarios to account for a significant drop in revenues or rise in expenses as well as re-forecasting quarterly to address shortfalls and control costs. “If you don’t understand the profitability drivers of your business, you’re just shooting in the dark,” cautions Matthews.
Trim the fat
Typically, businesses that produce or distribute products have lower profit margins than those providing services due to the higher overhead, inventory, and investment costs. However, there are ways to reduce fixed as well as variable expenses by “scrubbing” each line item in your P&L statement. Matthews sees opportunities for savings in both fixed and variable costs, such as renegotiating a longer lease for a lower monthly rate, changing your phone plan to eliminate those unused minutes, or encouraging energy savings among your employees. Another tip: many retailers he has worked with have been able to cut their waste management costs by maximizing the amount of space in their refuse containers for less frequent pickups. “Saving a few percentage points here and there really adds up if you’re a retailer,” Matthews points out.
Matthews also recommends looking at “key performance indicators” to find those hidden costs within each line item. “By breaking down some of those higher P&L items into components, you can see more clearly what’s driving up your expenses,” he notes. “Labor can be broken down by number of hours and hourly pay to see if savings can be found by increasing staff levels to reduce overtime.” He also cautions against adding any unnecessary expenses. “One of the reasons businesses fail is that they use it to write off personal expenses like vacations or cars,” notes Matthews. “My business remains profitable because I keep the fluff out of my P&L statements.”
Know where your profits need to go
“To sustain itself and grow, a business must have enough positive cash flow to reinvest in the business and reduce outstanding debt,” explains Xavier Epps, founder and financial advisor of Woodbridge, Virginia-based XNE Financial Advising. Epps works with small businesses to help them streamline operations and be more efficient so they can be more profitable at the end of the day. After looking at profitability averages across various industries, Epps counsels his small business clients to aim for a net after-tax profit margin of around 17 percent, with 7 percent set aside for cash reserves, 5 percent for investing in assets/expansion, and 5 percent for paying down debt. While profit margins set for service businesses often exceed the average, goals for businesses that sell products hover around 11 percent, as the cost to produce and distribute these goods tends to eat into the margins. “Once we get to that goal consistently for a few quarters, we will look to achieve higher growth,” notes Epps.
Epps cautions against aggressive and costly marketing and advertising strategies and offering large discounts, which puts downward pressure on profit margins. “Sometimes these line items can account for 15 to 20 percent of expenses while profits remain flat,” says Epps. “Once those expense items are cut back, profit margins rise, as that money can be put toward reducing debt and reinvestment.” While Epps believes some marketing and advertising as well as discounting can be effective if there’s a clear return, putting that after-tax profit back into your business can be the most effective growth strategy. “By focusing on trying to improve or expand your product or service offerings, your existing customers will recognize that and recommend you to others.”
Smaller market requires larger margins
While many businesses keep prices low with the hopes of making a profit through high volume, Andy and Jennifer LaPointe take a different approach to their food consulting business in Elk Rapid, Michigan and gourmet food products business, Traverse Bay Farms, in nearby Bellaire. Their strategy is to target a smaller segment of the market more interested in quality over price.
“We go for the medium to high-end price range,” notes Andy LaPointe. “But to do that, we have to offer genuine value to our customers.” For the consulting business, this means offering clients more specialized services to help ensure repeat business. And by showing customers where the ingredients for their products come from and how they are produced through media content and celebrity testimonials, they are able to create a story for their brand. “People are more willing to pay if they understand the vision and value in your products,” explains Andy LaPointe.
Because they’re targeting a much smaller segment of the market with their products and services, there is less competition for that mid to high price point. However, that means they need their businesses to collectively generate profit margins of between 50 to 200 percent to not only survive but grow. The consulting business, which has less overhead and reinvestment needs, generates higher margins (100 to 200 percent), while their products business hovers on the lower end, as it has much greater overhead and reinvestment needs. In their forecasting, they add 30 percent to debt service and real costs, which raises the end price needed to maintain these profitability levels. “We know we have the cash reserves to absorb the costs of unexpected weather events that can disrupt production, without large price fluctuations to the end consumer,” notes Andy LaPointe. “The higher the margins, the more value I can add over the long term because I have the cushion to absorb missteps and/or changes in the market.”
Less overhead, higher margins
Maciej Fita launched his virtual search engine-marketing firm, Brand Dignity, just outside of Boston in 2009 with just enough money for a business license yet he’s been profitable since day one. “We don’t have office-related expense and most of our fixed costs are for software needed to keep us running,” Fita points out. “We do almost everything we offer to our clients ourselves.” Fita has software that helps him analyze cash flow, which he reviews at least monthly. “We’ve tried to be super-efficient with the way we spend cash.”
Through his industry contacts and networking, Fita has positioned his company as an expert in the field, so he has not had to spend money on outside sales. He’s also focused on partnering with other creative agencies that don’t offer SEO marketing solutions. Bootstrapping and minimal overhead have enabled Fita’s company to average profit margins of 60 to 65 percent. “Our industry is still kind of the wild west when it comes to pricing,” says Fita. “But we’ve stayed in the middle range, which allows us to offer an affordable solution while we continue to grow.”
“Running a business is not unlike managing a household budget but just on a much larger scale,” explains Matthews. “You still have to bring in more than you spend.” If your business is burdened with too much debt, it makes it that much harder to be profitable. “Just like having a mortgage on a house, you need to make more money to pay the mortgage,” notes Matthews. “But if you own the house outright, you could make less and still have money left over to invest.”