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From the Blog
Understanding the types of Profit
We all know the expression “Cash is King” – but often people forget today’s cash is driven by yesterday’s decisions on pricing, “ingredients” and running costs, all of which determine profit. The Profit and loss report gives you the information to track and manage your sales and expenses and help you run a profitable business. But when it comes to looking at your Profit & Loss (P&L) report what are all those different kinds of profit? – Gross profit, Operating profit, Net profit and then your accountant might talk about the Bottom Line – is this before or after tax? And then investors might ask you about EBIT and EBITDA… lets get demystifying! First up a quick caveat – for some bizarre reason, some of the terms I am going to explain are defined slightly differently by different accountants and also whether you are UK or US based – so don’t be phased by this and there is no need to feel embarrassed to ask for clarification. Here is a typical summary of your P&L report “Standard Terms” Explanation Sales Sales invoiced in the month – NOT cash received and excluding VAT if you are VAT registered less Cost of Goods Sold The “ingredients” costs ie bread/mayo etc in a sandwich businesS = Gross Profit Think of Gross Profit as your value added – this is what you are in business to create ie in a sandwich business you took bread, boiled eggs, horseradish & anchovies and turned them into a high value sandwich – my favourite! less Overheads The fixed costs of running the business ie rent, marketing, office costs = Operating Profit Operating profit which is before interest and tax, helps you compare profit between periods irrespective of the level of borrowing, interest rates or tax. Also known as EBIT (earnings before tax and interest) less interest = Profit before tax Also known as PBT less Tax = Profit after Tax Aka “the bottom line” Let me explain the types of profit Gross Profit – this is sales less cost of goods sold and represents the “value add” that you are keeping. This is at the heart of your business model and your job is to push sales and cost of goods sold as far apart as possible but consistent with giving customers a “value proposition”. It is the Gross Profit generated that will cover overheads and make a profit. Often especially creative businesses do too much “polishing” of their product ie spend too much on ingredients (because they love it) – as a result they lose value and give it away to customers. Operating Profit is Gross Profit less Overheads. It shows the profit of operations – before interest and tax. It is also known as EBIT – earnings before interest & tax. EBITDA is your EBIT with depreciation and any amortisation added back. They are added back because they are both just accounting entries not reflecting cash – so EBITDA can then ne used as an approximation for cash flow by investors. You will also come across the term margin in relation to profit as in Gross Profit margin and net profit margin. What this does is express the profit as a % of sales to help track movements in underlying profitability. So for example: Month 1 Month 2 Sales £400 £500 Less Cost of Sales £100 £150 = Gross Profit £300 £350 Gross Profit Margin 75% (£300/£400×100) 70% (£350/£500×100) By using the % you can see that while the amount of gross profit in £ has gone up the profitability has gone down from 75% to 70% – maybe this was planned but maybe this is because of inefficiency in portion control or maybe a member of staff is pinching cash from the till ie sales were really £600 in month 2… That covers the terms – so the big question is what should you be looking at? – all of them and on a regular basis! The Gross Profit will show you how profitable you are at producing your good or service. The Gross Profit Margin (%) will help show the trend in efficiency. The Operating profit or EBIT shows how good your housekeeping has been – keeping your overheads as low as possible to retain as much of that Gross Profit as you can. And the key thing is to get regular management accounts so you can pick up issues as soon as possible. If the only time you look at the accounts is at the end of the year – start doing it more regularly and see how the improved profit management flows into CASH!
Why a realistic Sales Forecast is crucial for your Cash Flow
If there is one crucial piece of financial management you must do at whatever stage you are in your business – you must prepare and regularly update a cash flow forecast for at least the next 9-12 months. And the most important line in the cash flow is the sales assumptions – being up or down on sales will have a direct and possibly major impact on cash. Given the uncertainty around sales forecasting it is tempting to say why bother. I can understand this feeling. However you will find the process of undertaking a sales forecasting exercise incredibly useful and later I will discuss some techniques to help you. If you are starting up then all the clichés around “taking twice as long and costing twice as much” are sadly true. Getting customers and making sales is the toughest and actually most expensive activity the business does. You need to understand your sales cycle – how many contacts does a customer need before they buy (at least 4 usually) or how many visitors do you need to the website to make one sale. If you are starting up, you may not have any historical information to extrapolate from there are people with experience who can offer you realistic guidance on your assumptions. And documenting your assumptions or metrics as they are called will help you set your marketing/selling priorities. This will give you targets, month by month to aim for. This will also act as an early warning in case your business model isn’t working. And if you are already well established you still need to forecast to minimise the danger of over trading. Over-trading is when you expand too rapidly and run out of working capital (because money is tied up with customers and in stock less what you your suppliers). This is exactly what happened to children’s rainwear business Baggers – they launched, and grew the business to £1m+ sales but without enough working capital to fund this expansion Here are my Top tips to help you with your sales forecasting. Break your forecast into blocks. The first block is distribution channels – this is how you reach your customers. For example a skin care company might do online sales and via the high street, so you would separately forecast online sales and high street. Then for each channel forecast each main product category and do this using quantity x price. By analyzing each element you are building confidence (and investor confidence because they can follow your story). The focus initially is very much looking at the quantities and what drives the quantities. For an online freemium business model you would need to make an assumption about what % of visitors take the free offer and what % then go on to the paid service (usually quite low!) and don’t forget churn – the lifespan of your customers. As part of your sales forecast do bear in mind seasonality eg August holidays and crucially the rate of build up of sales. It is a common mistake to underestimate how long it takes to build up sales, especially when you are an unknown brand. The biggest strength of the US economy is its customers who are willing to give new products a go. In Europe a new customer typically takes 4 contacts before buying (maybe less on the internet) but its still a big cost/resource that you mustn’t underestimate. This is why investors pay such a lot of attention to the marketing section of your business plan which sets out how you are going to build that bridge to your customers. Finally always do a sensitivity a “what if” – what if sales are up 10%, what if they are down 10% – what is the impact going to be. So having constructed your first draft forecast what’s next? Well you need to “realism” test it. You can do this by networking with people in your industry, finding out about the growth rates of their companies. I have found people are very happy to talk about their business – especially with a bit of flattery. But what if your product is really a first, well you can look at growth rates of companies selling to similar customers at similar price points eg in fashion how long did it take LK Bennett to get their 10th shop? It’s all about realism and reasonableness – this is the objective for your sales forecast – to be reasonable. And whatever you do, if you are approaching investors, never ever describe your forecast as conservative. They have just seen too many “conservative” forecasts missed by a mile…you are aimimg for realistic.
Keeping Your Receipts (sensibly) Saves you Cash
The admin of running your business can seriously take the fun out of being in business unless you are careful. Obviously getting paid is the biggest pain, and next? Well I reckon keeping track of your receipts. At the end of the week there they are stuffed in your wallet, in the footwell of the car, in pockets of your jacket – and if you don’t get a system to record and file them you will lose cash. You can’t claim an expense on your tax return without a supporting “voucher”. All those small receipts for parking and stationery will mount up over the course of the year. Something like 40% of a small business expenses are less than £10 individually. And if you just stuff them in a bag waiting to deal with them in January when you tackle your self assessment… what a nightmare. So, here is my strategy for dealing with expenses: 1. Routine – make dealing with expenses part of your weekly routine. For example on Friday mornings, develop a checklist of all those boring but essential jobs you know you need to do like invoicing, chasing cash and, yes, administering your expenses. 2. Ask – Make sure you always ask for receipts and put them in a sensible place while awaiting recording eg I use a clear zipped wallet which I keep in my day bag. 3. Recording them – most people use a spreadsheet or paper based expense claim type form. These are fine but technology has moved on a long way – you can now use your smartphone camera and a program like Receipt Bank to capture and record your expenses digitally and also get them into your accounts. 4. Distinguish – Please note you need to distinguish between expenses that you have paid for out of your own cash and those you have used a company credit card to pay for. The latter are not part of an expense “claim” – you will need a separate wallet for receipts that are based on using a company credit card. These need to be attached to your credit card statement when you check it – is this on your monthly checklist?!… 5. Can you claim? – Rather than always wondering if you can claim an expense, create a checklist – There is lots of free advice online–especially on the Free Agent website. 6. Keep copies – Be aware that you need to keep copies of your receipts for at least six years! You are allowed to keep Digital copies and clearly they will be a lot easier to store. But I would recommend using an app that is designed for this rather then something you have created yourself. Now, if you are looking at a massive pile of unrecorded expenses that need to be recorded for your self assessment, don’t panic. There are plenty of people on services like People per Hour who would be delighted to process them for you. But please do start the new year resolved to keep on top of your expenses! Johnny
Use xmas downtime to boost cash
The start of the year is a good time to tighten up on cash – but its much more effective to do this before the start of the year. That way you will hit the new year running! So why not use some of that xmas downtime to look at these areas: 1 Give your personal budget a makeover – the less you have to take out of the business to fund your lifestyle the less pressure you will be under. Here is a great budget spreadsheet courtesy of moneysavingexpert.com 2 Do you have too many projects on the go? If so, you may suffer from lack of focus. Nick Roberston founder of ASOS said recently: “no one goes bust through being too focused” . Your key limiting resource is time – so don’t spread yourself too thin. 3 Do you see regular management accounts? A lot of businesses just get annual accounts six months after the year end – what good is that. Good management accounts should be out quickly after the month end and will show you how you are doing and highlight areas that aren’t working according to planned assumptions. 4 Documentation – More cash is lost through lack of documentation or poor documentation than any other reason. If there are important agreements that aren’t in writing yet – get them in writing! 5 Sales forecasts – most business plan unravel because the sales target is unrealistic – usually not in the level of sales but how quickly it is assumed the business will ramp up. Also the forecast is a wish rather than based on some kind of assumption eg number of sales calls which lead to y% meetings which lead to x% sales. 6 Intellectual Property – virtually every business is dependent on its IP for competitive advantage – make sure you understand how this area works. If in doubt there are some great resources at the British Library. 7 Managing Working Capital – working capital is money owed to you by customers, plus money tied up in stock less what is owed to suppliers. You can have a fast growing profitable business that comes unstuck because it runs out of working capital. So take time over the break and review how you chase outstanding debtors – do you have set procedures that are always followed? eg puuting accounts on hold when terms are exceeded? And also have a look at stock holding – do you carry too much stock. Taking time to look at these areas shouldn’t spoil Xmas and will generate much needed funds for the “bleak mid-winter” – but please try and make it part of your regular weekly and monthly routine next year.
How flat rate VAT scheme might save you cash!
As this article is about VAT – I am unusually going to start with a health warning. Don’t mess with VAT authorities – if sales of your business are likely to be £81,000 or more you have to register for VAT. And while most of VAT is straightforward there are lots of wrinkles to catch you out – so take professional advice before you get in trouble. Getting a bad VAT record is actually a real pain – eg it will lead to more frequent inspections etc. And when you are VAT registered DON’T look at your bank balance and think that is all yours – some of it will be owed for VAT. As a VAT registered business you are an unpaid collector of tax! So what’s the flat rate scheme all about? Here are 3 steps to understanding it. Step 1 – what is the flat rate scheme? It is a scheme to make accounting for VAT easier for small businesses. Rather than the usual method of adding up sales VAT and taking off expense VAT, you apply a % to your sales including VAT and pay that. The % is set by HMRC depending on what you do. For example secretarial services is 11.5%. Some numbers might help explain this… Sales £100.00 + £20.00 VAT Expenses £20.00+£4.00 VAT In a regular VAT return you would pay over £16.00 (£20.00-£4.00). However if the % was 10% for your type of business (to make the math easier to follow) you would only pay 10%x £120.00 = £12.00 a saving of £4.00 Step 2 – can anyone do flat rate? No – you have to apply to the scheme and you can only join if your sales are under £150,000 when you join. Once on the scheme you can stay on it until sales reach £230,000. Step 3 – would it benefit me? Basically it suits businesses with relatively small VATable costs eg a consultancy/service type business where most costs are labour. The above is very much a Numbers Coach™ simplification of the principles and, as you can imagine, there is more in the detail! So I suggest you read this great article by Emily Coltman Chief Accountant for Freeagent who make online accounting software. The article also has a link to a handy calculator to see if it will save you cash. If you are still using spreadsheets to run your business, please believe me when I say that it will save you so much time to use an accounting package when you are VAT registered.
Why percentages (and ratios) can save you cash!
There is a common misconception that an experienced finance person can look at a set of management accounts and highlight one or two numbers that indicate the health or otherwise of the business. But this isn’t how it works – because every business is different and has different relationships between the numbers. So what is important is not the absolute values of individual numbers but to establish trends – and this is where percentages (and ratios) can really help you. Let me give you an example – say you are running a restaurant – if you worked out wages as % of sales you could see if your rota is getting more or less efficient. Similarly if you calculated how long it was taking customers to pay (called aged debtors) you could see if you were being more or less efficient in getting in the cash. So while 250+ page books have been written on business ratios – the two main areas you should focus on are profitability and working capital. Let me give you an example of working capital: For working capital there is a measure called “debtor days” or “aged receivables”. To calculate this: Take credit sales (ie excluding cash sales) for the past 3 months and divide by 92 to get average daily sales for the past quarter Find out the balance owed by customers at the end of this period Divide this balance by your average daily sales and bingo you get debtor days – the number of days on average your customers are taking to pay. For example: Credit Sales for quarter £184,000 Divide by 92 = £2,000 per day If customers owed the business £70,000, then £70,000/£2,000 = 35 days! Ie it is taking customers on average 35 days to pay. Your job is then clearly to manage this to the assumptions in your business model by seeing how this moves month by month – you now have a tool to see the trend. If you would like to find out more about profit ratios then do have a look at my book “Understanding Your Business finances”. All of this of course pre-supposes that you have a proper accounting system to produce this information to calculate the ratios and percentages!…
Let your Chart of Accounts save you cash
Your chart of accounts (CoA) is the list of headings (or homes) that your accounting package uses to categorise your business income and expenses. By grouping transactions in sufficient detail you can really understand whats going on in your business. For example rather than just recording marketing as a lump sum, break it down further eg Pay per click, PR, trade shows etc. By breaking costs down into smaller components you can much more easily see the spend that is going on and as the cliché goes – you need to measure it to manage it. So having identified the right level of detailed reporting for your costs you can use this to set the budget. (Designing the layout of your CoA is so important that it is worth getting help on). So how can the CoA save you cash? Well firstly with a computerized accounting system you can easily run a report that compares actual spend with budget – if spend is running higher than budget this will be shown by an unfavourable variance. And this should prompt you to investigate why this has happened ie why is spend running ahead of budget. Also you can run a report that lists your costs and spend for the current month and year to date. What you do with this is as follows: get a cup of coffee or tea get a ruler and pencil slide the ruler over each cost and spend information and think really hard how this can be reduced, is it necessary? For those items that you think are too high – run a print out of all the transactions in that account. You may find some have been entered in error – but the remaining transactions should be scrutinized for wastage or over spend For those accounts that you have identified where savings could be made – start a system of re-negotiating and re-tendering to get better deals. If you haven’t done this exercise before my guess is you will be able to reduce your overhead costs by at least 9% – good work!
Good Documentation Saves Cash
January can be a pretty tough month for trading after the hump of Christmas – unless you happen to be a fitness coach or selling diet supplements…so as well as reviewing your marketing plans, use the time to make sure you have all your business arrangements properly documented. In my experience more cash is lost because of unclear and undocumented business arrangements than any other reason. What kind of things should you be thinking of? Well are you in business with a friend with no written agreement? Do you not have a shareholder agreement? Do you have terms of trade with your customers? Any “employees” or freelancers without contracts? Are you doing work without a written agreement/specification eg building a website without clear payment milestones. Have you borrowed money from a family friend? All these need documenting What’s the best way of doing the documentation – just do it! An exchange of emails is better than nothing. Obviously important agreements require a lawyer (typical cost £750-900 per agreement) – but the next best is a DIY approach using online templates for example from www.simplydocs.co.uk .
“Thank you for your brilliant jam packed day on finance at LCC. Believe it or not I came home and began sorting things out straight away, as tired as I was. Much to be done! As I mentioned to you I work at the Royal British Society of Sculptors as the Education Projects Manager and organise professional development seminars for sculptors on various aspects around making a living. It would be wonderful if you could lead the seminar on finance coming up.”
“Thank you very much to the connection to your film. It is really very good and I agree with you about the necessity for training people to understand this stuff by taking the mystery out of it. To be honest there are a lot of people who are already supposed to be in business who could use a simple refresher on many of these points.”
“I really enjoy your classes. You cover the important topics that we need to learn step by step, and like Weronika said you add a human touch to what would otherwise be numbers numbers and numbers.”
“This enterprise and financial management in cultural production has been an enjoyable and high level learning experience and I feel that the method and techniques related to finance, I learned on the unit helped me to make this business plan much better than if I had tried to develop such a project without the theory.“
“I looked through your videos – they look good and the principle behind it is definitely useful, and I think there could even be an idea of EMCA students viewing them before starting the EMCA finance unit, so could be a great way of getting up to speed.”
“I thought the course was fabulous because I actually understood the basic principles of cash flow, balance sheet and profit and loss. The course was taught in a less formal way than one would in a financial training course which made it easier to understand to learn. Overall, I really liked the course, I found it very helpful and it’s been really great of you to upload all the documents, excel models after each class. I really learned a lot and enjoyed it!”