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If its foundation is weak, will it be possible for a building to stand high?
The answer, of course, is ‘No’.
Yet so many business owners and aspiring entrepreneurs seem to be lacking on a fundamental piece of running a successful business, which is understanding the core mechanics of how a business runs, and not taking the necessary steps to address this illiteracy.
People fail to understand the difference between Revenue and Gross Profit, and seem thunderstruck when they hear about COGS, SG&A and EBITDA.
Come on Ilias, you are just making up random words now, right?
The only way to truly assess the status of your business is to calculate critical financial numbers, track them over time and analyze their meaning and underlying implications.
These numbers are going to tell you whether that new product you just launched is actually generating profits, and whether or not the Return on Investment of your latest marketing campaign is positive or not.
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Needless to say, if you are a business owner or aspiring entrepreneur, you absolutely need to know your numbers and also understand what those represent and mean for the financial health of your company.
The problem is exacerbated by the fact that the numbers by themselves can be sometimes misleading. You need to be able to understand their true, often hidden, meaning.
An elegant quote that encaptures the spirit of the basic financial numbers is this:
“Revenue is Vanity. Profit is Sanity. Cash is Reality.”
Let’s elaborate on those.
Revenue is Vanity
One of the biggest mistakes made is focusing only on the “top line”, i.e. your company’s revenue. People get fixated on that figure because it is the largest one, since it has not yet been reduced by various costs and expenses, and also the simplest one to calculate.
The truth, however, is that revenue is largely meaningless if you are not aware of the general context.
For example, if someone mentions that his business generated $1 Million in sales last year, is that good or not?
Well, it is impossible to know! That number alone says absolutely nothing.
If the overall Net Margin of the business is 3%, then Net Profit is a measly $30,000. Even worse, if overall costs amounted to $1.2 Million that year, the business generated a loss!
Now, don’t get me wrong. Generating and increasing Revenue is absolutely critical for a business. In fact, with weak revenue, a business is doomed to fail. Yet, you need to understand how that revenue is generated, and what is left off it, after all expenses are deducted.
On top of that, what you also need to see is Revenue Growth. The only way that a business stands to be more valuable in the future, is to generate an increasing amount of revenue (and profits subsequently).
Finally, as the case is with most of these financial numbers, you need to compare revenue with other companies within your industry. Otherwise, this comparison might not make much sense.
Profit is Sanity
The next commonly used figure is that of Profit. Profit is essentially what is left, after all expenses have been accounted for.
Profit is a much better indicator of a company’s health than revenue and it is regularly used to gauge the value of a company (particularly for stable, mature ones).
Here is an example that highlights this.
At the time of writing this, the most valuable company in the world is Apple. In 2016, Apple generated an astonishing $215 Billions in sales.
During that year, Wal-Mart, the world’s largest retailer, generated around $478 Billions in sales, more than double!
Yet Wal-Mart is only around tenth in the list of most valuable companies in the world (by market value).
How is that possible? The answer is Profit Margin and Profit of course.
During that period, Apple generated $45 Billions in Net Income, while Wal-Mart “only” managed to generate $24 Billions.
Bottom line here is that Profit (or Net Income) is a much better indicator of a company’s financial performance.
However, profit has its own limitations too. The most basic problem here is that profit is essentially a “mirage”, since it might not have materialized yet.
For example, if you book a service for a client that will generate $100K during the next year, and your cost of delivering that service is $20K, in theory you have a healthy profit of $80K for that transaction.
However, until the payment is actually performed and the cash is in your bank account, that “profit” is hypothetical. Quite often, you might not be able to actually collect payments that you have already considered a “done deal.”
This issue is especially prominent in B2B transactions, where the clients usually have a leeway of paying for your services during a period of 30, 60, 90 or even more days.
Another problem with “profitability” is what happens when the business you are examining is in its infancy and during a high growth phase.
During that period, the business operators might willingly choose to keep the company “unprofitable”, or just barely break even, while heavily reinvesting the proceeds into the business.
In those cases, “gross profit” might be a better indicator since that figure does not take into account expenses that are actually growing the business, like marketing, equipment etc.
Cash is Reality
Finally, perhaps the most accurate and representative financial number, is that of Cash and Cashflow.
Cash in the bank cannot be disputed. It is actually there. Whether it has come from retained earnings or by the surplus of revenue minus the costs, its presence is reassuring for a business owner.
A critical question to periodically ask is, “How much money is there in the bank?”. In times of turbulence, cash can bring peace of mind.
At the same time, positive cashflow is another powerful indicator of a healthy business. It means that you are generating revenue, you are able to collect it, you are in position to pay all your expenses (payroll, vendors etc.), and you are still left with some.
Note that we can drill down even further. Cash flow can be categorized into Operating Cash Flow (OCF) and Free Cash Flow (FCF).
Operating Cash Flow is a measure of the amount of cash generated by a company’s normal business operations. It indicates whether a company is able to generate sufficient positive cash flow to maintain and grow its operations, or it may require external financing for capital expansion.
Free Cash Flow is Operating cash Flow minus Capital Expenditures (CapEx). FCF represents the cash that a company is able to generate after spending the money required to maintain or expand its asset base. FCF is important because it allows a company to pursue opportunities that enhance shareholder value.
Shareholder value can be increased either by reinvesting in the business (when in Growth phase) or by throwing out dividends (when in Maturity phase).
Free cash flow is perhaps the most powerful indicator that a company is healthy and growing.
At this point, I should make a note for those companies where the owner is actively engaged in running the company. In these cases, when calculating FCF, we should assign a salary figure for the owner whether or not he is actually drawing one.
The reason is that, if we wish that business to be a standalone, sellable asset, it should be in position to operate without the owner. For that to happen, another person would have to replace him or her, thus a “market value” wage should be assigned.
Understanding and tracking your critical financial numbers is a highly important activity that might make or break your company.
Don’t be deluded by the sexy allure of high revenue if that is not based on reality. All basic numbers, Revenue, Profit and Cashflow, are critical for understanding your company’s health and should be used in conjunction to paint a picture of what is truly happening.
Accounting and understanding financial statements are some of the skills that every entrepreneur needs to master in order to become successful, so make sure to cultivate some expertise on those fields.