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How to do business succeed? Calculate gross profit margin by hand

Here’s the best advice I’d give anyone who wants to start a business: from day one, calculate your monthly sales and gross margin by hand. Do not use the computer. Write the numbers, segment by product or service and by customer group, and do the math yourself, using no modern tools other than a calculator.

That’s what I asked Bobby and Helene Stone to do (see chapter 1) and it’s what I did when I started my business. You can save yourself from any calamity and increase your chances of success many times over, if you do the same. After all, to be successful in any business, you need to develop the ability to sense numbers. You need the ability to judge the relationship between them, see the connection, find the number that is especially important and needs to be tightly controlled. The numbers run the business, they will tell you how to make the most money in the shortest time with the least effort, this is, or should be, the goal of every entrepreneur. And then, when you have a lot of money, what you choose to do with it is another matter. You can donate all of that money to charities if you want. But first, you have to make money, and the numbers can tell you how to do it effectively, but provided you understand their language.

Looking up numbers by hand is the best way I know to learn and understand their language. You can process numbers with a computer once you’ve mastered this, but if you let a computer do the work from the get-go, you’ll lose your sensitivity to numbers. In fact, your business may never have been viable if you hadn’t tracked the numbers in the first place.

Consider the case of Anisa Telwar, who founded Anisa International in 1992. Business was in trouble when she contacted me four years later. She said she pushed sales of her makeup and cosmetics business from zero to $1.5 million, “…and I have nothing to show for that growth at the moment.” She thinks what she needs is better motivation, but I think her problem lies elsewhere. But anyway, I agreed to meet her.

The story quickly reveals that Anisa has lost her way. She realized something was not going right because she was having trouble paying her bills every month, but she couldn’t figure out why. She clearly knows the cost she spends as well as how to price the product. But why is she so often short of cash? She realized the problem was because she didn’t have enough revenue to pay for other problems. In fact, the real problem was that she wasn’t looking for simple sources of information that would tell her what was going on with her business.

There are only two possible explanations for Anisa’s case.

One is that she doesn’t earn enough gross profit on sales to cover other expenses.

The second reason was that the cash she earned didn’t go into her bank account, but elsewhere. The second reason doesn’t seem to make sense when it comes to her line of business. She is in the business of packaging and marketing makeup brushes, cotton, bags and gifts. She sells them to major department stores and cosmetic companies throughout the United States. Anisa will take orders and ship them to the manufacturer in the Far East, who will then ship them directly to the customer. The producer will receive the money after she receives the payment from the customer.

So I knew that her cash wasn’t going to the factory: she didn’t have any. Therefore, I suspect that your problem is debt related, given the pressures in paying suppliers that you are under. I guess she has too many deals with low gross margins.

But which deals, and why?

Are you pricing some products too low?

Is she giving too many favors to certain customers?

I couldn’t figure it out because she didn’t record the numbers. I asked her to go back and rewrite the parameters of the sales contracts for the last three months, showing the total amount on each invoice and the cost of goods sold for each of those orders.

After looking at the numbers and the list of contracts, I realized that she had a client problem. She lost money on some orders and in others, she didn’t make enough money to stay business.

Then I sent her a form, and asked her to start tracking sales and gross profit by product group.

At the end of each month, she will write down the sales, cost of goods sold, gross profit, and gross margin (that is, percentage of gross profit on sales) for each product she offers in that month and from the beginning of the year until then.

Then she will calculate the total sales, profit and coefficient profit margin for the company as a whole. This entire workout requires less than 30 minutes per month and allows her to immediately see how much cash she’s making and where it’s coming from. Meanwhile, she continues to track sales and monthly gross margin per customer in another sheet of paper.

The report gave her a clearer view. Anisa later told me that this was like being hit hard. For the first time, she understood the price she had to pay to be profitable in business. She said she didn’t care about it before, but now she has begun to understand how she needs to control it, which will prevent her from suffering from low gross margins. While business is doing well with some products as well as some customers, other things drag the business down from average. I told her there were four basic ways to handle a situation like this. She can raise prices or reduce production costs. She can say no to deals with low gross margins, or she can find products that can be sold with higher gross margins. And Anisa decided to do it all four ways.

You should understand, the problem here is not that Anisa made the mistake of accepting deals with low gross margins in the first place. When you first start out, you have to be flexible, having to assemble each part of your business like a jigsaw puzzle. At that point, these low gross margin deals will help Anisa build relationships with suppliers by providing enough value for them to allow her to get credit. business. As she soon realized, their credit was key to her survival.

But as soon as she discovered a way to make a living from the business, she should have immediately focused on increasing profitability but she didn’t because she didn’t understand what was going on. She was not aware of the decisions that needed to be made. She runs instinctively and gropingly, rather than based on information, and the business needs numbers to survive.

You need to collect that information in the first place. Specifically, you need to keep track of your gross profit margin. High gross margin means high gross profit, and high gross profit is the primary source of cash needed to support yourself and build your business.

And don’t follow the numbers by machine. You have to write them down by hand and calculate the percentages yourself. If you let a computer do this for you, the numbers would become abstract. You won’t get them, don’t understand them as well as you should if you really want to control the business.

Don’t get me wrong, I don’t mean “against” computers. In fact, I used computers in my delivery company earlier than most other companies in the same industry. My companies always use the best technology. I myself have all the latest computer equipment. But seven years after I built my record-keeping company, I was still tracking the key numbers by hand every month and by then my company had millions of dollars in revenue.

Those are all the most important parts of the training process, and you can’t ignore it. I don’t care if you’re a Harvard MBA and have been at McKinsey for ten years. Even so, you still have to keep track of the numbers manually. Surely when you do it yourself, you will learn as much as what Anisa learned. With her newfound knowledge, Anisa was able to take charge of her own destiny and built Anisa International into one of the nation’s leading makeup brush suppliers. In 2006, Target Corp. named the company Sales Company of the Year in the field of cosmetology, and the company also received an award for its position as a supplier of outstanding business illustration, innovative design, and customer service. The most amazing item. Anisa might never have been able to have those things if she didn’t really understand the numbers. Following them manually in the first place helped her develop that ability.

FINANCE LEVERAGE

I have failed to overstate the importance of developing a good sense of numbers here. Specifically, you need to identify numbers that can alert you to potential problems, so you can make timely decisions to prevent future problems.

I’ll tell you an example from my record keeping business. In the spring of 2003, we were all gearing up for a growth spurt when I received a two-page report for each business every Monday morning. Among them, the record keeping report tells me how many new boxes we saved in the last week. Over the past several months, the number of boxes of records has been steadily increasing as our Manhattan clients, usually law firms, accounting firms, and hospitals are working to move their records outside. outside after 9/11. In one year, we grew 55%. But when I looked at the report that morning, I was shocked to realize, last week, we stocked 70% less new boxes than the week before.

I seem to be dumbfounded. New box count is one of my most important numbers – a reliable indicator of last week’s true overall sales. Although the new boxes represented only one element of my revenue, by then I had understood that our revenue was directly proportional to the number of new boxes we received. On September 1, let me know the number of new boxes received in August, and I can tell you our total sales for August with an error of only 1 to 2% of the actual number. If new box numbers drop as reported, we’d probably face a serious drop in revenue growth.

That’s important information, and I wouldn’t have realized it so quickly if I hadn’t discovered a formula to calculate total sales based on the number of new boxes. For starters, it’s clear that there can’t be such a formula. We derive revenue from a variety of sources, including optional services, shipping costs, and special projects, not to mention the cost of storing the boxes we already have. New boxes represent only a small percentage of our total sales. If I don’t have a key figure, the main source of revenue, I would have to add up all the revenue from different sources to get the total revenue figure. In practical terms, this meant we had to wait until the monthly bill.

But I didn’t have to wait that long, and I knew I didn’t if I could find a number that grew at the same rate as total sales. After years of research, I finally focused on the number of new boxes and was able to come up with a formula that allowed me to predict sales with an error of only 1 to 2% of the real number. Why is the number of new boxes? I have not found the reason yet. This is similar to the ability to determine a store’s revenue by counting the number of pairs of shoes sold. But, for some reason, this formula really works.

I believe every business has such key numbers. One restaurant owner I know was able to predict his evening bill by the time a customer had to wait for a table at 8:30 p.m. My friend Jack Stack, co-founder and CEO of SRC Holdings Corp. and a pioneer in open management, told me about an owner of a gear manufacturing company who was able to figure out the company’s revenue based on the volume of gears shipped. Not from cash, not from orders, not from the number of gears, but from the volume of gears sold.

In fact, all of the most successful entrepreneurs I know have certain key numbers, and they track them on a daily, or weekly basis. It’s an important part of running a successful business. Key numbers give you the information you need to act quickly. Business changes very quickly, and so you can’t wait for monthly, quarterly or annual reports from your accountant. By the time you get them weekly or monthly it’s time to go too far, and you can only deal with the consequences that arise. If you continue to wait until the reports are available, you will definitely miss a lot of opportunities. You need information at the right time, the only way to get it is to create a series of simple calculations you use to find out what is going on in your business at any given time.

One of these calculations must be related to revenue, although I must emphasize that it is not recommended to use only one. If you just track sales, you’re in serious trouble. Revenue does not make a company successful, only profits and cash do. Many companies go bankrupt because owners focus so much on revenue growth that they overlook profits and cash.

Of course, having a key figure for revenue is important. Each industry will have its own dominant number and it is rarely obvious. I often have to stick to the numbers for years before I can determine a single calculation that can be used to quickly determine revenue.

Consider the destruction business we built in the spring of 2000. As I mentioned, we have revenue from two types of businesses. A service called full destruction of records, we destroy large amounts of sensitive documents that customers have hoarded for a long time. The remaining service is for regular customers that provide data that needs to be destroyed periodically. In those cases, we place locked boxes around the client’s office.

The revenue from the full destruction service is easy to track because we only do a few deals per month. The bin shredding service requires closer monitoring as we have different types of bins, different sizes, different emptying cycles etc. So it takes a lot of factors to make up the total. turnover. After three years of close follow-up, I still can’t pinpoint a key figure for revenue in bin shredding. The number of new buckets can also be a dominant number, or it can also be the total number of unresolved buckets or it can be the number of empties. Also it can be the sum of any other numbers. In the end, after thorough research, I came to the conclusion that the total number of bins scanned weekly is the number that is best proportional to the total revenue. But it took me a long time before I could understand the relationship between the numbers.

How important is it to businesses to find key numbers? See what happened at the record company after I noticed the drop in new boxes. At that time, we were constantly recruiting. We needed a lot of people to handle all the new arrivals, and we had to hire four times as many people as we needed, because normally it would only be one in four new hires. recruited to stay with us. When I saw the number of new boxes drop, I immediately thought that my growth rate would also drop, which meant we wouldn’t have enough cash as planned. Maybe the drop is just a strange one-week phenomenon, but I don’t want to assume it’s just luck. If our annual growth rate actually fell by the same amount as the filing box, that would mean we’d have 30 employees left over. While we could let the normal process of layoffs take care of itself, I don’t want to keep the people who recruited at the rate of the original plan. If sales don’t come back up, we’ll be forced to lay off employees.

Therefore, based on the number of cases per week, I proceed to suspend the recruitment of personnel. “I want to protect the jobs of current employees,” I said. “Let’s see how this works.” We expect revenue to rebound, but the decline continues. When a one-week drop turns into a month, and then four months, it means we’re clearly not dealing with an unprecedentedly tough situation. The market has changed. Apparently, the customer destroyed all the documents they wanted to move after 9/11. Although our sales continued to grow, the annual rate fell from 55% to about 15%.

My warnings in this regard have been proven, this is the best consequence of having a dominant number. My employees were amazed how quickly I recognized the drop in my growth rate too soon and then quickly acted. I tell them it’s all about the numbers.

THE PRICE FOR GROWTH

Let me talk more about the importance of tracking numbers other than revenue, especially cash flow. Revenue is good, profits are even better, but the survival of companies depends on cash flow. Most new entrepreneurs don’t understand that high revenue usually means low cash flow and low cash flow means trouble.

As always, I draw this from my own experience. When I started building my first company, I had no concept of the relationship between revenue and cash. I think revenue is everything. If someone came and asked me to make a $1 million deal, the only question I would ask was, “When is it going to happen?” I accepted all the deals I could get, as quickly as I could, and so the company flourished. Our revenue grew from zero to $12.8 million in five years – fast enough to make it to the Inc 500 list. 1984. We had a cash flow problem, but I didn’t care much for it. I’m too busy selling products.

Ask Norm

Dear Norm:

I have reached the stage where I need to move from using two part-time accountants to one full-time employee. When I was ready for a change, I wondered what number I should be tracking on a daily basis.

Gary.

Dear Gary:

Every business has its own key numbers, I guess you already know yours. How do you know if you have a good week or month? What happens when revenue drops? How much time do you need to collect the debt? Those are all simple, meaningful things. Your finance officer should help you figure out what numbers you need to track and then provide them to you periodically. When you interview new accountants, make sure they’re qualified for your job. If you feel like you’re not good at keeping track of numbers, don’t be afraid to admit it. Ask the candidate himself the problem. If they can’t give you the answer, don’t hire them.

– Norm

One final blow – cash scarcity forced me to work four weeks in a row without pay. Elaine was very upset. “What do you mean, you can’t pay your own wages?” she speaks. “I think the business is very successful and the turnover is very high. How do you still have a good business and not bring home a dime in four weeks? Please explain that to me. It is absurd.”

The truth was I couldn’t explain it to her because I didn’t understand it myself but I realized I’d better figure out why. Finally, I found it. What I learned is that you have to be farsighted. You have to figure out how you can get the cash needed to increase sales by whatever percentage you want. Otherwise, you will put yourself in a dead end. I’m talking about losing control of the situation, about your decisions, about being forced to do extreme and foolish things in order to survive. Working without pay is just the simplest way. Some people even evade income tax, which is not only illegal but also stupid. Meanwhile, the creditor will smack you because you can’t pay your bill on time. It was a nightmare.

So how do you plan for growth? More precisely, how can you determine the additional cash needed to cover new sales? First, you need to ask the right questions about the new deal:

1. How much is it worth and in what timeframe?

2. What is the gross profit margin?

3. What is the total cost you have to add?

4. How long do you have to wait for payment?

If you can answer these four questions, then you can make a rough estimate of the additional cash needed for the deal.

Let’s take a look at an example. Let’s say you expect your sales to increase by $100k next year. Your gross margin is 30%, and you don’t expect to change this number on a new deal, but you know you have to add $10,000 in total costs – commissions, expenses books, and other things. You expect the average debt turnaround time (collection period) to be steady at 60 days.

And here’s what you need to do:

Start by figuring out the cost of goods sold (COGS) in the new deal, the amount you pay to manufacture or acquire any product. Since your gross margin is 30% of sales, your COGS accounts for 70%, which is $70k. Adding in the total extra cost – $10k – means you need $80,000 to cover a new $100k order. Divide that total by the number of days on the deal – 365 days in this case – and you’ll find out that the new deal costs you $219.18 per day. You then multiply that amount by the number of days it takes to collect the debt, you will find the amount of cash you need to replenish. To be on the safe side, I’ve always calculated a 20% increase in collection time, so in this example, I’ll multiply by 72 days, instead of 60 days. The result I get will be: 72 days x $219.18 per day = $15,781.

However, you need to remember, it is a rough and pragmatic formula. Some people may argue that it is based on ambiguous assumptions – such as that you will pay all your bills at once. But conceptually, prediction means incorrect. You need some simple tutorial tools. These tools will help you reasonably predict your future cash needs, and they will show signs of danger that you need to watch out for.

What will you do with this information? Obviously you don’t want to turn away from good deals, with high gross margins. So you look for ways to replenish your cash. You may shorten the collection period, prolonging the payment by a week or two. You can negotiate with new customers to make them pay faster. Or you can go to your primary supplier and say, “I have good news for both of us. I just had a client who’s going to do a lot of business with us, but I’m going to have to delay your payment date from 40 to 60. Can you handle that?” I am sure that there will be very few suppliers who refuse.

And lastly, you can always borrow more money if you don’t mind adding more bank debt and increasing costs. Then you may again have to decide to work without pay for a few weeks. I haven’t chosen that path myself in years and would definitely avoid it whenever possible. I’m sure my wife feels the same way. She wants me to get paid weekly and so do I. It gives us the feeling that we are in control of the situation. In business, you can’t control the situation if you don’t have cash on hand. And this is worthy of the first lesson that entrepreneurs need to learn.

Ask Norm

Dear Norm:

I am an artist and professional tennis player with a sports training business, teaching tennis through tennis matches with music and some special lessons. I want to grow the company, and I have the passion and long-term vision to do it, but I don’t have the business background. Can I become an entrepreneur or do I need to find someone else to grow my business?

David

Dear David:

I guess you have more business skills than you admit. You have customers, right? You must be able to sell and market, and those are two of the most important skills of an entrepreneur. You may not know accounting, but that doesn’t mean you can’t learn about numbers, and it’s the numbers you need to know, not the accounting profession. My advice to you is to go ahead. The only way to gain experience in business is to join it and deal with it. You cannot succeed without trying. In the worst case scenario, you will also learn great lessons for your next business.

– Norm

LAST PRICE

Ultimately, of course, the result of building a business is the reward you get for selling the company. Unfortunately, many business owners miss out on that bonus or a big part of it, because they don’t understand the factors that go into it and don’t keep track of the financial statements that help them get the full value. value of what they create. But those losses haven’t stopped entrepreneurs from exaggerating the true value of their companies.

Companies on Inc.’s annual 500 fastest growing companies list. is a typical company to learn from. I went through some of the resumes they sent to the magazine. I remember a company that had lost about $60 million in revenue the previous year, but when the owner sent us the application, the owner still thought his company was worth about $50 to $100 million. Apparently, they didn’t know what happened to unprofitable Internet companies in the 1990s. Another company had a net profit of approximately $335k on $6.5 million in profit. profits – and the owner still thinks his company is worth $100 to $200 million. In fact, half of the business owners I consider offer their companies ridiculously high prices. The rest are insanely high.

I can easily understand the CEOs and former CEOs of Inc. 500 understands that thought. After all, we tend to overestimate our egos, which isn’t always a bad thing. But you need to build a business fast enough to get on the Inc.’s list. and egos that are too big can get us into a lot of trouble valuing the company. We often apply the highest price we know to a company like ours and then adjust it.

But it’s not just fast-growing companies that charge more than they’re worth. Consider a deal recommended by my former associates in the destruction company, Bob and Trace Feinstein. They heard that there was a small company for sale. The owner asked for twice the company’s annual revenue, about $1.2 million. Since other shredders had been selling for three times their annual sales, Bob and Trace thought we should buy it. In fact, they made a common mistake we’re talking about.

You cannot determine the value of any company simply based on its revenue. The truth is that every business has a way of estimating a price, and it’s usually expressed as a multiple of revenue, but that’s simply out of people’s habits and convenience. What most corporate acquirers are interested in is free cash flow, and free cash flow is a function of profits, not sales.

Turns out, the company Bob and Trace were talking about was barely profitable. All that makes up that company is a father, a son, and a truck with a shredder on it. All they care about is making a living, which they can achieve by doing mass destruction for incredibly low prices 6 cents/pound. They did everything on their own, but this business was completely worthless for a company like us.

First, it will cost us more than 6 cents/pound just to collect the paper and make sure the destruction is done safely – regardless of the costs incurred. Of course, the two of them can forget about the total cost: because they don’t have one. They cost them nothing but the actual cost of providing the service. As a result, they can survive without making a gross profit. It is the gross profit that will help cover the costs and provide the net profit needed to build the company and profit from the investment. We would never consider buying a business without gross profit. We won’t even buy their list of customers because when we charge them the actual price, the chance of retaining those customers is completely zero.

So you might ask, how can the father and son value their business at $1.2 million? They calculate the way most people do. When you hear a company in the industry selling for three times its revenue (or whatever), you naturally think your company is worth the same, just as you would. think your house is worth about the same price as the downtown apartment that just sold, you don’t even know what the furniture is in the apartment and why people want to buy it.

Finally, I help break free of that trend by talking to people interested in buying my company, and I recommend other business owners do the same. You need to start by understanding what potential buyers are looking for. Of course, that very much depends on who the potential buyer is. Some buyers buy companies for strategic reasons, because they want to gain market share, others because they see potential for synergies, and some because they want to boost profits. However, whatever the motive for the need to trade, they still need to check earnings before interest, taxes, depreciation of intangible assets and depreciation of tangible assets or EBITDA (Earnings Before) Interest, Taxes, Depreciation and Amortization) of that company to ensure a level of safety. When you subtract this number from the minimum new capital (or Capex) each year, you get your free cash flow. This means you can see the cash the company will collect for one year after paying all operating costs and expenses and meeting the minimum refinancing requirements but before paying all taxes and fees. interest (these are costs that are not payable by the purchaser of the company) and before deducting the depreciation of tangible assets and amortization of intangible assets (considered a mechanism that reflects the cost and life of the asset). some asset classes).

Assuming the buyer can determine your company’s EBITDA, other factors will still contribute to their final decision. I use the word “assume” here because most small companies do not have audited financial data and track financial statements well enough for them to be able to accurately predict EBITDA. Without this information, you certainly won’t be able to sell your business to an experienced buyer, and of course you won’t be able to sell at a premium.

However, just because your company has a good and stable EBITDA, and you can prove it, that doesn’t mean you have nothing to worry about. Buyers will want to know where that EBITDA is coming from. Do you have a large and diverse customer base? Will they sign a long-term contract with you? Is your price in line with the market?

I know a guy in the business where some companies can sell for three to four times their sales. He wants to sell his business and can’t understand why no one wants to buy it. The problem was that he had a few big clients that made up more than half of the company’s revenue, and they paid a lot of money. That could happen. It is possible that a certain customer always increases purchasing power for the company, but does not receive a reasonable discount. Maybe the employee underestimated the customer, or didn’t do the job properly. As soon as the customer realizes that, you lose the business. If it is a customer that accounts for a large percentage of your revenue, your losses will be heavy.

Wise buyers will keep these potential dangers in mind and then rely on them to instantly lower the price of your business or they may decide it’s not worth buying.

But let’s say you have an efficient company. The price you can offer will most certainly be between five and ten times EBITDA. (Here, I exclude companies that are just “concept,” or at least those with huge growth potential, pricing based on their own rules.) The exact multiples are based on. on many factors, such as interest rates. As those factors increase and money appreciates the multiples tend to go down. If they go down, the multiples will usually go up. The multiple is also influenced by the level of competition among potential buyers and the number of good companies being offered for sale, as well as other factors related to your company. But either way, it should be somewhere between five and ten times EBITDA no matter what industry you’re in.

Why? Because what the buyers of the company need is the potential for future profits. The more profitable the company, the more willing they are to pay expensive. Conversely, the greater the cash flow risk, the lower the price they offer. But, clearly that multiple isn’t what industry insiders will tell the collector about your company after they’ve paid you, nor is it how you say what price you’re selling for. Instead, it should be a multiple of revenue or some other approximation that is familiar to everyone. For example, in the record keeping business, we often hear that someone has just sold a company for a very high price per box. That may be true if the collector just wants to buy customers and boxes, but if selling the entire company, the rule of thumb is a form of (symbolic) quick calculation. Regrettably, it is this that causes people like the father and son of a car shredder businessman to have a skewed view of the value of their company.

So does that mean that the father and son will never sell the business? Not necessarily. I don’t think anyone with any sense would pay $1.2 million for that company, but it’s still worth it to a suitable buyer, more precisely, someone like them. The first question is, will the business generate enough cash so that the buyer can make a living from it and still have enough money to cover the monthly payments for the father and son, say for 5 or 6 years? ? The second question is, is the acquisition better for the buyer than the self-starter? I can’t answer those questions, but I hope the two entrepreneurs can figure out the answers before planning a break based on the money they get from selling the business.

KEY POINTS

First: Whenever you launch a new business, track your monthly sales and gross profit until you can get a good feel for them.

Second: Find the key number, the number that shows how your business performed, before the business report.

Third: More revenue always means less cash flow. Figure out your future cash needs while you still have time to generate them.

Fourth: Understand EBITDA, and use a multiple of EBITDA not sales as your measure of the value of your business.

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