The FINANCIAL -- Other possible titles: “Three Numbers That
Mean The World,” “Three Numbers That Can Kill Your Business (Or Make It
Thrive),” “Of Money And Metrics: Three Numbers Every Business Owner
Last week’s column focused on how to help your company survive its first disaster. A key component of survival is having enough free cash to deal with disaster. This week, we are going to look at how to track your cash, using the three important numbers that all businesses need to continually monitor. The numbers are cash burn, net profit, and cash flow, and if you know what these numbers are and where they will be in the future, you can predict the success (or failure) of almost any business. For large companies, these three metrics, or measurements, are the most important factors affecting stock prices. Reviewing these numbers for your business every single day will focus your thinking and help you make the critical decisions that lead you to success.
Metric One – Cash Burn Actual / Cash Burn Planned. “Cash burn” describes the difference between how much money you planned to spend and how much you actually spent, and tracking it is critical when you are building your business infrastructure. Every entrepreneur should have a plan, whether starting a business, opening a second location, or investing in some other business expansion. That plan should include cost information for each of the elements of business infrastructure needed to begin operations.
Some small business owners might have their plans written on a piece of paper. Some might have it in the computer in Word or Excel. Some might have projections documented in a formal business plan, while very small entrepreneurs might just carry lists of things they need to do and buy in their heads.
No matter how sophisticated or basic your planning process, you can still track cash burn. Add up all of the money you have spent, whether you planned to spend it or not. We will call this number “actual expenses.” Next, add up the money you planned to spend on the items you have already purchased. Do not include items that you still need to buy. Do not include items that you forgot to include in your original plan. We will call this second number “planned expenses.” Finally, divide actual expenses by planned expenses to find your cash burn ratio.
If the result is over 1.0, you are spending money faster than you expected. Without extra cash reserves, you will run out of money. You should consider finding additional funding or altering your plan to reduce your initial cash outlay.
If your result is less than 1.0, you are spending money more slowly than expected. This is a good place to be, because it means you should have extra cash left over for future needs.
Let’s explore a simple example: Irakli, a 14 year old boy, decides he wants to start an on-street car wash business. He needs to find a bucket, a bottle of soap, a tire scrubber, and 10 towels. He comes up with a budget of 40 lari to start up his business. His uncle loans him the money and Irakli goes to the market.
At the market, Irakli’s friend tells him that he needs THREE buckets instead of the ONE in his original plan: one to carry things, a second for clean water, and a third for soapy, dirty water. Irakli thinks about the suggestion and decides his friend is right. He buys three buckets and the bottle of soap as his first purchases. Having just read this column, he decides to check his cash burn ratio. He had planned to spend 10 lari for a bucket and 5 lari for soap, for a total of 15 lari. Instead, he spent 35 lari, giving him a cash burn ratio of 2,3 (35/15). He knows that he is spending money much too quickly and must change his plan or get more cash. He decides to secretly use his mother’s towels instead of buying them at the market, and he asks his friend for an extra 5 lari to help buy the tire scrubber. He comes up with the physical things he needs to open his business.
Irakli’s example was very simple, and he really didn’t need cash burn ratio to tell him he didn’t have enough cash. However, when a plan becomes even a bit more complicated, it is very easy to miss important items and overspend. From NASA going to Mars to Trump building a new casino, almost everyone misses estimates. It is important to track your cash burn because this metric will warn you in advance of a coming cash shortage.
Metric Two – Net Profit. Net profit is the difference between the price a business sells something for and what it costs them to provide it. There is no better predictor of business success than a business’s profit trend. Even the smallest company MUST track their profit per sale and their total profit for each month. Go to Google and look up examples of income statements or profit and loss statements for small businesses. As you will see from the examples: Profit = Sale Price - (Sale Cost + Other Expenses). You need to track this information every month. Let’s turn again to Irakli for an example of how to calculate profit.
Irakli charges 7 lari per car. This is his sale price. He has direct costs for soap, and for towel washing and wear reserves. These direct costs total 1 lari per car. He also pays a local lady 10 lari a month to use her water and spends 2 lari per day on transportation to get from home to work and back. He washes on average five cars per day and works 20 days a month.
Irakli’s per car gross profit is 6 lari (7 lari sale – 1 lari soap and towel expense). Every month Irakli makes 600 lari in gross profit (6 lari per car x 5 cars x 20 days). However, he still has to deduct his monthly expenses of 10 lari for the water and 40 lari for bus rides leaving him with 550 lari net profit (600 – (10 + 40)).
After a single month in business, he will make enough money to pay back his uncle and buy his mother a new set of nice new towels.
Now, though, Irakli is not satisfied with his 550 per month net profit. Because he read this column, he decides to use math to make even more money. He tests another car washing location on the other side of the city, two hours away from his house by bus. In this new location he can charge 10 lari per wash, but he only has enough time to wash 4 cars per day because he has to travel back and forth from home to work. Based on the math, did he decide to move locations? What would happen to his monthly profit if he decided to take a taxi to work every day, giving him enough time to wash 6 cars, but costing him 18 lari a day for the round trip? If you had Irakli’s business, what would you decide to do?
Net profit is the most important metric a small business own can track. It is critical to know how to calculate net profit and understand the factors that contribute to it. Look at the Google examples and write out your own income statement. If you haven’t opened your company yet, estimate what the numbers should be, then compare those estimates to the actual numbers are after you start operations.
Metric Three – Cash Flow. Cash flow is essentially the change in available cash a company has from one day to the next. Neglecting this third critical metric has killed many otherwise successful companies. Many small businesses begin operations with cash on delivery, or COD, terms. In other words, when they buy things, they pay for them immediately. When they sell things, they are paid immediately. Sometimes, however, there is a delay between when a business needs to purchase something and when they can sell it.
Imagine, for example, a small furniture maker. This manufacturer must buy wood and other raw materials to build the furniture before they can deliver it to a customer and collect payment. If the furniture maker accepts a large order, they might not have enough cash on hand to buy raw materials for the project. What happens to the manufacturer if they pull together all of their available cash for materials and complete the order, but then their customer pays two weeks late?
The company will not be able to take any new work, because they don’t have cash for materials. Too many late paying customers can kill a new business.
Let’s go back to Irakli for a moment. Imagine that a local company asks him to wash their fleet of 25 cars, twice a month, for a total of 50 washes. He can’t do the work himself, so offers his friend a part time job. Irakli will give his friend all of the supplies necessary and pay him 4 lari per car. He agrees to pay his friend once every week.
The company, however, asks Irakli to give them an invoice and will only pay him once per month, 30 days after he submits his invoice.
Even though Irakli is making 5 lari per wash, yielding an extra 250 lari per month in net profit, he still must come up with enough cash pay his friend and buy supplies for 60 days. Irakli needs 500 lari in cash, just to take the company’s business.
Thinking about cash flow is critical for all companies, and managing it well can be the difference between life and death for new businesses.
Conclusion – Track the Trends. The metrics above are critical to monitor when starting any new business. What is even more powerful and often overlooked by small business owners is something called trend analysis. Tracking a trend is as easy as comparing the values of one metric at two different points in time. Every mother in the world has done trend analysis with her child’s fever. When Irakli was sick as a child, his mother noticed that at 21:00 his temperature was 38 degrees Celsius. Later that evening, at 23:40, it was 40. His temperature was trending up and she was worried. A few hours later, his temperature had come down to 39 degrees and she felt relieved. She was relieved because the temperature was trending in a good direction.
Trends in business are the same as trends in temperature. Looking at the trends of your three most important metrics provides valuable information about the actual health of your new business. In many cases, trends in metrics like net profit are more important than actual the numbers themselves.
Would you rather own Market A with a 5.000 lari monthly net profit or Market B with a monthly net profit of 8.000? Most people would pick Market B making 8.000 lari per month.
Imagine, though, that you saw a profit trend where Market A, now making 5.000 lari a month, was only making 1.000 per month a year ago. Assume that the trend was consistent, with profit increasing incrementally each month during the past year.
Now imagine that you also saw a trend where Market B was making 9.000 lari per month last year and their profit has been slowly decreasing each month.
Which market would you rather own now?
Understanding metrics and trends is critical to success in any new business. Analyzing these important metrics is not complicated and can be tackled by anyone with basic math skills. Knowing the trends in these numbers will help you make better decisions that ensure your success.