Build a Better Business Podcast

65 – The Interior Design of Your Business: Financial Systems

3 Key Points in this Episode:

  1. The three mistakes most small business owners make when creating financial projections.
  2. Create a budget, cash flow statement, and establish key financial indicators.
  3. Sales is not cash, gross profit is not cash, receivables is not cash, CASH is cash!

Show Notes:

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* Disclaimer – The information in chapter 6 is based on my own individual experiences as an entrepreneur. I am not an accountant or a lawyer, it is essential that you always consult professionals when making financial and legal decisions.

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Building a home is a huge expense. If you are borrowing money to finance the project the bank will often require a financial plan and will only release funds in stages as the house is being built.

Starting and building a business can cost similar amounts of money and in some cases even more money than building a home. Despite the significant amounts of money involved it still surprises me how many self-employed people are operating without a financial plan or even a budget.

This is one of those areas where knowing how to do a job does not prepare you for running a business that offers that service. Most self-employed people have very little training or experience with the financial part of running a business. I know I fell into this category when I started my first business and even the first couple years of running my contracting business.

Operating Capital; do you have enough?

People say that “cash is king” and this sentiment is not far from the truth.

When planning and launching a business one of the most frequent challenges is raising enough money to launch and develop the business. It almost always requires three or four times the amount of money you initially think it will require and six or eight times as long to develop and launch the business as you originally expected.

New business owners will often use a calculator or spreadsheet to figure out how many units they will need to sell or how many jobs they will need to book each month to pay for the business expenses and their wages.

They look at the cash reserves they have and figure out how much runway they have, which is often no more than three to six months. They assume that they will be able to find the minimum number of customers to purchase the minimum number of products or services to pay for expenses within the time frame they have cash reserves for.

Next, they extrapolate that set of metrics to a point where they will be making hundreds of thousands or millions of dollars personally and this becomes their long-term goal.

Then they make the common mistake of making that their financial plan.

There are many problems with this; let’s break it down one mistake and one step at a time.

Mistake 1 – Believing there is a correlation between how much money you have and how much money you will need to build and launch the business.

What should you do?

Wouldn’t it be wonderful if the exact amount of money you have saved to start your business was the exact amount of money you needed to start and establish your business?

What would the odds of that happening be?

According to Forbes, 80% of businesses started each year fail in the first 18 months which indicates that the odds are not in your favor.

Figure out how much it will cost to build and launch your business, then find the money.

Mistake 2 – Assuming you will be able to find enough customers within the timeframe your start-up funds allow for.

What should you do?

Since there is no connection between how much start-up funds you have and how long it will take to find customers, you need to take a different approach.

The best advice I can give you is to develop a beta version of what your business will offer. Then test it in the real world. You can offer a free sample or even create a waiting list for your service. By creating a place for real customers to indicate their level of interest you can measure many metrics that will tell you how long it will take to find enough customers to make your business viable.

Once you have tested your product and service and have collected factual data, you can then establish a financial plan based on accurate information. Most businesses will run a deficit for the first few months, even up to a year, but no longer than that. You need to have the money in place to take care of startup expenses and to cover the deficit while you establish the business.

Mistake 3 – Extrapolating the financial plan to show massive growth and resulting personal wealth.

What should you do?

While you need financial projections and a business that serves a market that is large enough to support your plans to scale, focusing on fantasy numbers is like fantasizing about winning the lottery. Although fun, it serves no practical purpose and can cause you to make very poor decisions.

Instead be realistic and conservative.

I have been told that the big 5 banks in Canada have a procedure in place when evaluating business plans. Apparently, they will cut sales projections in half and double projected expenses. If the business is still viable, they then begin the process of evaluating the financial projections further, and even if the plan is still viable after these drastic changes there is no guarantee of being financed.

Regardless if this is true, it demonstrates that entrepreneurs, small business owners like you, need to be very cautious about projections. Being conservative is the best plan.

Now many people begin to feel overwhelmed at this point.

“How do I save up enough money?”, you may be thinking.

When we started our contracting business we only had $700.00.

Certainly, not enough money to start a contracting business with.

In addition to our $700.00, we had a deal with a general contractor. He loaned us the equipment to get started and he provided us with $90,000.00 in work that first year. All we had to do was get the equipment to the job sites. We spent our $700.00 buying a utility trailer that we pulled with our personal vehicle.

So, you can start a business right now, with very little money.

What you need is to find customers pre-launch, make deals with suppliers in the industry that you will operate in (deals that are mutually beneficial) and have a plan of how you will transition from initially self-employed (owning your own job) to becoming an entrepreneur (owning a business) that meets the criteria of a great business.

Sometimes when I give people this advice they push back and say something like, “I can’t do that” and to that response I say, “then don’t start a business”.

The reality is that when you are a business owner you need to make deals, deals with customers, suppliers, lenders, and investors. You will not magically become a deal maker because you launched your business.

It is like when you get married. The type of dating relationship you have is the type of marriage you have. Just because you have a ceremony and throw a big party you don’t magically change into different people.

If you have money troubles before the wedding, you will probably have even worse money trouble after the wedding because of all the expenses of the wedding. If your relationship has been difficult before the wedding, nothing is going to change because you got married, and adding children to the mix certainly won’t make the problems go away.

It is no different when you are about to launch a business. Like in a marriage, you can learn these skills, you can in time change and become better. But also, like in a marriage, it only makes things easier if you get to work on making those changes before the wedding.

Think about how you can acquire customers pre-launch, what deals can you make with suppliers to reduce your startup costs, and who can you bring into the business that will become either a lender or investor and will give you reasonable terms?

Now is the time to do this work. My advice is to just ask people. You may be surprised at the positive response you get.

Developing a budget

We have already discussed the need to be conservative when you are making projections for sales and profit. It is just as important to be realistic about how much things cost. Sadly, everything costs more than you think.

Often, it is the small expenses that you don’t notice that add up and erode your profit. Creating a budget for the big expenses is usually not that difficult. Accounting for all the unexpected expenses can be more difficult.

In our contracting business, we created a monthly budget for our business. All our fixed expenses were in a column, they included things like bank fees, telecommunications, fuel, equipment maintenance, insurance, municipal, provincial (state), and federal taxes and fees, payroll, workers compensation, and safety board fees, accounting fees, and legal fees. Some of these we paid monthly, some quarterly, and some annually. They were very consistent amounts with variables that we could easily calculate and project.

An example of this was we knew the percentage we paid workers compensation, so if we were entering a busy period we could project the number of hours our employees would work and then we could accurately project the amount we would owe to workers compensation.

An area that would cause us trouble was what we called variable spending. There was a lengthy list of things that I would have to purchase as we were doing jobs that were just not predictable. $15 here, $10 there, and at the end of the month it would add up to $1000.00 or more.

It was never a problem accounting for those expenses after the fact. I always kept my receipts and our office would enter the expenses into our accounting software, so we would be able to take advantage of tax breaks and write-offs.

The problem would be that when we ran our projections on sales, profit, and expenses we would never make as much money as we anticipated. This caused all kinds of problems as the situation compounded throughout the year. Somehow these unaccounted variable expenses would end up on a credit card and over time we built up a considerable amount of unsecured debt.

In time, because of our excellent record keeping, we could forecast our variable expenses with more accuracy and this led to changes in our pricing so that we could be profitable, and the business became more predictable and manageable.

Without accurate budgets, you are blind. Your pricing may be too low, you may think you are profitable but be going into debt, and the result can be the demise of your business. As with every aspect of your business, creating systems is an important part of building a business that operates predictably, independently of you the owner, scales, and can be sold for a profit, if you choose to do so.

When we ran our contracting business, we had a system for submitting receipts, recording the expenses in our accounting software, and then creating a budget that accurately showed us all our expenses and assisted us in making projections and financial decisions.

If you or someone in your business are not able to do the bookkeeping I highly recommend that you hire someone who is proficient. As well, it is important to have an accountant and lawyer that you trust and will give you solid business advice about any financial aspect of your business. This is one area that you should never cut corners on while trying to save money.

Your cash flow plan

I’m embarrassed to say that when I was running my contracting business it took several years for us to realize we needed a cash flow statement. We kept running into the same problem, sales were good, receivables were being collected, expenses seemed to be normal and yet, I was having to use my credit card to make necessary purchases.

Why wasn’t their money in the bank?

Sales is not cash. Gross profit is not cash. Receivables are not even cash. Cash is cash.

Money flows in your business, it moves through your business in and out of departments, some systems make money, some systems spend money, and finally, after it is all over, an amount of money called “net profit” or “cash” is left over.

Understanding where the cash is at any given time is what a cash flow statement is all about. Without a map of where the money is, like when I needed to use my credit card to make necessary purchases, you may find that the money you think you had is temporarily unavailable or worse yet, doesn’t exist.

The part that really upset me was that after years of struggling with this it took about 15 minutes to find and set up an Excel template that worked beautifully for us. Once we imported the financial information we had a clear picture of where the cash was and when it would be available for us to use, and more importantly, how much of it we would have when it was all over.

This proved to be an invaluable resource. Of course, up until that time I had sales projections, I had a budget, I could tell you how much receivables and payables our business had, I could tell you how much gross profit we were projecting, I could even tell you how much net profit we projected, but I couldn’t tell you when all of that was going to happen.

With a cash flow statement in place, I could pinpoint when we would have a cash problem, we could see how when sales went up, it took a certain number of days for cash to arrive in our bank account, and this was a revelation. I now could see that the rise in sales also caused a rise in expenses and if the cash had not arrived from the last increase in sales we would have a problem paying for the additional expenses while we waited for the cash to arrive.

I’m tempted to share with you the cash flow statement we used but I have decided that it isn’t important which cash flow template you use, your accounting software may have a template, or you may use an Excel template as we did, what is truly important is that you use one.

Don’t wait like we did, if this all seems totally over your head then have some conversations with your accountant and get them to help you set up a system that allows you to easily access and understand your cash flow.

Your profit analysis

I want to repeat something for emphasis:

“Sales is not cash. Gross profit is not cash. Receivables are not even cash. Cash is cash.”

Cash, in my opinion, is the only number that truly matters.

When every bill is paid, how much money do you have left?

As a small business owner, everyone gets paid before you do. Your employees, suppliers, lenders and sometimes even your investors all get paid first, whether you make money or not. There is one more important entity that gets paid before you get paid.

The government.

Don’t mess around with the revenue agencies. The municipal, provincial (state), and federal agencies all must get paid. That includes safety boards and worker compensation.

It is no wonder that as a small business owner you may feel like you are a conduit for cash. Money flows into your business and then flows out at an alarming rate. That is why how much money is left over when everyone is paid is all that matters.

Let’s have some fun and play a “Pick Your Own Adventure” game.

You’re an entrepreneur and you have a choice between the following:

$1 Billion in sales or $1 Million in sales.

Naturally, you would pick the $1 Billion in sales, that would be awesome, but what if it costs you $1.5 Billion? Losing $500 Million dollars is not my definition of success.

Now, what if I told you that the entrepreneurs who chose the $1 Million in sales had a net profit ratio of 10%. I don’t know about you, but I would rather pick the $1 Million in sales if it resulted in earning $100,000.00 in cash over losing $500 Million, wouldn’t you?

One of the most common objections small business owners get from customers is the price. If we are being honest, we have all lowered our prices to get a sale, and if you haven’t it is probably because you haven’t opened for business yet.

Customers often have little concept how much it costs to provide products and services. Sadly, many small business owners don’t either. They forget to include all the little variable expenses into their price and ultimately, they generate sales but insufficient profit.

Your business needs profit to exist otherwise it will fail, sometimes quickly but more commonly, very slowly. The business owner is constantly having to invest more money into the operation to keep it going, the business bleeds the owner and its investors dry, and then when the lenders have had enough and stop loaning money, the business collapses under its own financial weight.

Money.

Sales, Expenses, Gross Profit, Net Profit, Cash.

Most small business owner’s greatest weakness is in the financial end of the business. I can’t stress this enough, you must find accountants and lawyers you can trust but more importantly than that, you must educate yourself.

How else will you lead your business?

How else will you create the necessary systems to ensure that your business is predictably profitable when you step out of the day-to-day operations and when you scale the business?

I’ll admit something to you, I am no different, I have struggled with this for years and I deeply regret the time and money I wasted by not taking control of this aspect of my business and for that matter, my personal finances.

Learn from my mistakes and do the work necessary to ensure that your business will be predictably profitable.

Key financial indicators

Your business is the sum of many moving parts, those moving parts make up systems and those systems make up your business.

Key financial indicators are an early warning system that alerts you to danger and tells you when you are financially secure.

What key financial indicators should you establish in your financial system?

One business owner may feel that one indicator is more important than another but again what is important here is that you understand your business and which indicators matter to you.

In my contracting business, we tracked many indicators across the entire business’ financial system and I will share them with you but remember this is what mattered to my business and is not a complete list.

  • Sales – Projected vs. actual, compared to historical sales
  • Estimates – Estimates requested converted, compared to historical conversion rates
  • Expenses – Projected vs. actual, compared to historical expenses
  • Gross Profit – Projected vs. actual, compared to the historical gross profit
  • Net Profit – Projected vs. actual, compared to the historical net profit
  • Cash – Peaks and valleys, projected vs. actual, compared to historical cash flow

By understanding these key financial indicators, we understood how successful we were, when things were changing, and if we were making progress over time.

Your accountant will be able to help you decipher which key financial indicators are important for your business and develop a simple system for extracting these indicators from your accounting software.

In conclusion, this chapter about the financial systems of your business was designed to help you think about your financials in a different way. It is essential that you educate yourself about business finance, that you use a bookkeeper, accountant, and lawyer that you trust and that YOU design the financial systems of your business.

It is no one else’s responsibility, don’t abdicate control to someone else because you feel under qualified. The financial health of your business is your responsibility.


This episode sponsored by:

Trackstar Web Design

Every business needs a website and I have used Gerrit and Trackstar Web Design since 2012 and so should you.

Process Street

I use Process Street to create systems in my business and I highly recommend that you use Process Street as well.


Thank you for listening and I look forward to working with you soon.

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