Business Advisor Network Blog

It is often mentioned the importance of monitoring a wide range of ‘performance indicators’ in a business, in order to ensure that appropriate and timely decisions and plans can be made. Given that sales, profit margins and cash flow are the lifeblood of any enterprise, you should put particular emphasis on the importance of getting regular reports on at least these areas of your business.

Alas, most businesses fail to do this.

Far too many businesses blunder their way through the year with little real idea of how they’re progressing. Sure, they might have an idea of what the sales figures for the month were – but less than 1 in 100 would know how that result compared against the same period last year, or whether the profit margins were fatter or thinner, or how many transactions it took to generate those results, or how quickly/slowly accounts are being paid and therefore how the cashflow looks, and so forth. In short, they don’t really know how they’re travelling and so they’re routinely disappointed by what they find on the bottom line at the end of the financial year.

Up to date and accurate financial information lets you make balanced, considered decisions about what you’ll do next, instead of having to rely on hunches and gut feel.

For instance, let’s say a retail business owner has been trading profitably for a while and has been offered the opportunity to take over the space next to his existing store, at a bargain price.

At face value it looks like a good idea. There’d be more shop front and so a greater ability to display merchandise and signage. There’d be more floor space which would allow for the stock to be displayed more attractively. A wider range of products could be carried, to cater for a wider range of tastes. The adjoining space has corner frontage, so two-street access and signage would be available. Extra parking is another bonus.

But is it really a good idea? A “break even” analysis will tell.

You can calculate Break Even by making the following calculation:

Fixed Expenses/Gross Profit ÷ Sales

So, if the business’ Fixed Expenses were, say, $150,000, the Gross Profit was $250,000 and the Sales Revenue was $1,000,000, then the calculation would look like this:

$150,000/$250,000 ÷ $1,000,000

In which case the Break Even would be $600,000. ($150,000 ÷ 0.25 = $600,000).

If the additional space was going to add, say, $30,000 per year to the Fixed Expenses of the business, then the Break Even would increase to ($180,000 ÷ 0.25 =) $720,000. In other words, a $30,000 increase in this business’ expenses would require an additional $120,000 in sales.

Is that realistically achievable? If you’re not sure, a “Volume Break Even” analysis will help determine the answer.

For instance, let’s say the business’ average transaction value is $50. (This would have been calculated by looking at the total sales made in a period of a few ‘typical’ months, then dividing that total by the number of transactions which occurred in that time. For example, if the business made $240,000 in sales in the previous 3 months and 4,800 sales had been recorded, then the average transaction value would be $240,000 ÷ 4,800 = $50)

We can now calculate the Volume Break Even by making the following calculation:

Sales Break Even/Average Sale Value  or: $720,000/$50  … which would equal 14,400 “average” sales.

That’s 2,200 sales more than the 12,000 required to break even at the old level.

Once again, is that achievable? The 2,200 extra sales amounts to an extra 44 “average” sales per week (over a 50 week year). That’s an extra 7.3 sales per day, if the business trades for 6 days each week.

Can the business reasonably expect to make that increased number of sales each day as a direct result of increasing its floor space?

But if it seems to be easily achievable … then the decision to expand would be a reasonable one. On the other hand, if it’s unlikely that sales would increase by the required amount … then the vacant space should be left vacant (or the rental should be re-negotiated until it is reduced to a level which makes it viable).

The point is, the analysis would have made that business owner really consider the ramifications of their decision. The extra $30,000 in rent might not seem like a lot … but the extra $120,000 in sales or the extra 44 sales per week might have been a whole lot more daunting. Or those targets might have seemed easily achievable.

Either way, you’d be a whole lot more confident that you’re making the right decision – and a whole lot less likely to wind up broke as a result.

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Every business aspires to make a profit which is where you sell for more than you pay. However, there are many types of profit that are used – many for different reasons. This post is designed to look at the common ones (and alternate terms or common abbreviations), explain what they are and what they get used for. I will start from the top of the profit and loss:

Gross Profit (also GP or gross margin or GM)
This is what a business makes from the direct activities of whatever it sells. It includes all sales (including time payment discounts, rebates, volume discounts, returns, etc) and all costs directly involved in the creation and its sale (materials, labour costs to make, delivery costs, etc). This is very useful to understand whether what a business sells has high margins or not – divide the GP by total sales and this gives the margin.

Net Profit before tax (also NPBT or operating income)
This is gross profit less all the general and operating costs and interest paid. Effectively it shows how efficient a business is converting the gross profit made on what it sells into profit. This is where overhead costs that are out of control become very apparent.

Net profit after tax (also called NPAT)
As the saying goes, the only two certainties in life are death and taxes. This is where whatever income tax is owing to the government is deducted. This does not include GST as it is effectively a net tax only (GST collected less GST paid) and is generally shown as a general expense.

Earnings before interest and tax (also called EBIT)
This is effectively net profit before tax with any interest paid costs added back in. It is used quite often in assessing the value of a business. The argument is that the way a business is funded does not affect a potential purchaser because they may vary its funding structure, so looking at what type of earnings multiple may be applied is done before interest costs.

Earnings before interest, tax, depreciation and amortisation (also called EBITDA)
This is the EBIT figure but with depreciation and amortisation added back. Amortisation is the same as depreciation but applies to non-physical assets (so goodwill is amortised). As financial accounts are prepared on an accrual basis, EBITDA is quite often used as a proxy for cash earned by a business as depreciation and amortisation are not cash items. Again it is widely used in assessing business values. Be very careful trying to use EBITDA as a business cash flow figure – cash flow is impacted by movements in balance sheet items like debtors and creditors.

I hope this makes all the funny acronyms a bit clearer.

Marshall Vann – Realistic Business Solutions

How to book a meeting with a business advisor, mentor or coach?
Find out about Government Grants for Queensland business?
Would you like to become an Accredited Advisor?
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I would love to have a dollar for every time I have heard a small business owner say “the accountant has the numbers”, which is then normally followed by some comment like “but I think things went well last year”.

Too many businesses use their external accountant as a crutch for managing their business, rather than as resource that can add valuable insights but ultimately have “all care and no responsibility”.

Many small businesses don’t pay enough attention to the regular production of meaningful business numbers. It is hard when there are innumerable demands on the time of an owner and only so many hours in a day. Inevitably the regular review of the results is shunted down to the end of the “to do” list. In some bizarre way, the introduction of GST in Australia together with the quarterly BAS did many businesses an immense favour – they are now forced to keep the management accounts reasonably up to date.

However, most need to be better at it. A jockey does not look up at the winning post and say “great we won, that’s a surprise”; he or she is forever reviewing their horse, the other horses, the course, the distance to run and other matters throughout the whole race. Crossing the finish-line first is an outcome of these efforts.

Such is business. You cannot rely on a “set and forget” budget. You must track how you are going through the year before getting to year end. You must see what your opposition are doing and adjust accordingly. You must know what every sale makes for you – both before making the sale and after it is completed. You also must know what is happening below the gross margin – this is where all the good work in making sales is generally lost. When an administration expense is $100 over budget, no worries. When a 100 of them are all $100 over budget, good bye profits.

These can only be tracked by diligent and timely review of accurate management accounts. You have invested in an accounting system – so use it properly. And help your accountant get on with value-adding, particularly in areas like knowing what your profit for the year will be before the end of the year.

Marshall Vann – Realistic Business Solutions

How to book a meeting with a business advisor, mentor or coach?
Find out about Government Grants for Queensland business?
Would you like to become an Accredited Advisor?
Need information on how to prepare a business plan?
Do you want a step by step guide to growing your business?
Become a sponsor or partner of BAN and connect with small business decision makers?
I wish to make a donation to help small business.