Finance tries to quantify business in monetary terms, taking account of risk and time. Interest rates reflect the cost of money over time and the risk of the borrower.Entrepreneurs spend one euro today and hope to make two in three years’ time, they track their progress using a profit and loss (P&L), balance sheet and cash-flow statement.
Profit and loss
A P&L measures the business’ performance over a given period of time. It is prepared monthly; displaying the current month and year to date, and last year as a good basis for comparison.
It matches the income of the business against the cost of goods (margin) and expenses incurred in earning that income. Costs are separated into costs directly related to goods sold and overheads.
The difference between sales and cost of goods sold is net margin. Overheads are paid out of margin. If there is anything left over, then that’s profit, representing the reward for those who put up the money to finance the business.
Margin is key to increasing profitability, monitoring changes in it and ensuring it is not given away needlessly. To achieve this, record your margin as product flows through your business, mainly at three points:
Unexplained stock losses traditionally run 3% to 4% in the hardware industry, e.g. sales of €2m typically
result in €80K stock losses, €20k caused by customers and €60k by staff. A cheque is not written for this
loss and so it may remain invisible; year-end stock takes may pick it up. Stock losses can be substantially reduced by quantifying them, reviewing business procedures, training and performing cycle counts.
Breakeven is the point at which a business is neither making a profit or a loss. If you know by lunchtime you have broken even, then the additional margin in the afternoon is yours, this reduces stress and builds confidence.
It is calculated by dividing the fixed cost by the margin %. The POS enquiries screen will show you sales and margin for the day, or a longer period.
Margin €500k 25%
[Breakeven is €400k =/25% = €1.6m sales/year]
EBITA €100k or €6k sales per day
Margin vs. Mark-up
Margin and mark-up are two different ways of expressing the difference between the cost of a product and its sale price. Traditionally, in the heavier end of the trade, a mark-up formula is used to set the price of a product, starting with the cost price. It’s simple and easy to guide sales personnel. However, the perception of high markup can be dangerous as it leads staff to discount more.
Margin works back from the sales price, it is more useful for analysing sales/expenses, e.g. breakeven and setting prices e.g. rounding up. The goal is to use margin analysis to adjust prices and determine what your markup formula should be.
Profit and cash flow are two entirely different concepts, each with entirely diverse results. The concept of profit is somewhat narrow, and only looks at income and expenses at a certain point in time. Cash flow, on the other hand, is more dynamic. It is concerned with the movement of money in and out of a business.
More importantly, it is concerned with the time at which the movement of the money takes place. The concept of cash flow is more in line with reality. To convert your profit to your cash flow, subtract increases in working capital, loan repayments, taxes paid, drawing and fixed asset purchases, i.e. this requires an examination of your balance sheet.
A balance sheet is a snapshot of the business’s assets (what it owns or is owed) and its liabilities (what it owes) on a particular day – usually the last day of the financial period, ideally monthly. Information is presented in descending order of liquidity. Buildings at the top, as they are the least liquid (difficult to turn into cash), then current assets less current liabilities, the net of these two, is working capital. Working capital is the amount of money a firm needs to trade, i.e. buy stock and give credit. In contrast to fixed assets, it is dynamic, difficult
and expensive to finance. Overtrading occurs when increases in sales in pursuit of greater profits strains cash flow. For example, take a builder’s merchant with €4m sales, who requires additional funding of €400k to increase sales by €1M to create an additional €250k profi t. Good payback at two years, but difficult to finance.
Fixed assets such as buildings and machines are long-term assets and should be financed by long-term finance, not by short-term finance such as overdrafts. Banks are willing to finance fixed assets as they can physically and legally nail them down. Typical methods are leasing and term loans, similar to a mortgage on a home.
Liquidity and solvency
A liquidity problem occurs when a firm can’t pay its bills as they fall due. In the recovery phase of the economic cycle, this is usually caused by overtrading. Poor liquidity can raise the concept of solvency, the ability of a business to have enough assets to cover its liabilities. Should a business find itself in an insolvent position, the directors should take legal advice, as to continue to trade may leave them open to allegations of fraudulent trading and to being personally liable for the debts of the business.
Directors also have a legal obligation to maintain proper books of records. Volume for vanity, profit for sanity and cash is king: finance tries to explain the relationship between these. It is not an exact science and it requires judgement. Owner/managers know their business in detail, they have an instinct for how they are doing; finance confirms or rejects this, by representing the business in facts and figures, especially at a summary level.
My top tips are:
-monitor margin changes;
-Ensure you have good processes in place, that gives you the vital information you require on time.
John Hassett is Owner Manager at Topline Hassetts, Birr, Co. Offaly. He is also a business coach and accountant with international experience. John will the trainer at a one day finance course HAI are running in September:
This article originally featured in The Hardware Journal, May/June 2015 issue.