“Only one who devotes himself to a cause with his whole strength and soul can be a true master. For this reason mastery demands all of a person” Albert Einstein. Running a small business is no easy task; it “demands all of a person.” Small business success requires passion, dedication and a mastery of the finances. A lack of understanding of finances has been the demise of startups and established organizations alike. The purpose of a small business ultimately is to turn a profit. A small business that cannot turn or maintain a profit needs to analyze its numbers in order to make improvements. Owners who have a deep understanding of their finances are more likely to survive and thrive in a boom or bust economy. In the following paragraphs we will discuss four finance related items every business owner should know.
Know Your Burn Rate
“Burn Rate” is a finance term used to discuss how quickly an organization spends money in a given time period. Every organization spends or “burns” its money at a specific pace. Every individual has certain habits that are repeated, often unknowingly. In the same way a business can develop certain spending habits or patterns. A small business owner needs to know and understand these financial habits or cycles to prepare for those times when revenue and cash is low. Knowing how your quickly a business typically spends can alert owners of potential problems like theft and erroneous charges to name a few. For example, let’s say an Accounting firm typically spends 30% of its $500,000 annual budget by March of every year. If that same firm spends 40% of its $500,000 annual budget by February then that maybe an indication of a spending issue. A deeper investigation is needed to uncover the root cause of this spending increase over the prior year. For example, did the firm invest in a large piece of equipment? Did the firm increase its staff size? Was there a spike in utility costs? Knowing your burn rate is like having a smoke detector in your home. It alerts you of a pending disaster. If action is not taken swiftly all could be lost. If a business situation like the one above goes unaddressed for the entire year this firm will experience lower profits and perhaps a deficit as a result.
Know Your Margins
Margin is a term every business owners should know and track carefully. The word margin literally means “the edge, border or extremity.” In the world of finance there are three types of margins. The first is gross margin. Gross margin is the difference between the total revenue of a product and the cost of goods sold. This figure is usually represented as a percentage. For example if a firm has $100K in gross revenue at the same time the materials to make those goods costs is $30K. That organization has net revenue of $70K. That firm has a gross margin of 70%. This means that firm usually converts 70% of its gross revenue to net revenue. The higher the gross margin the better. Gross margin is computed by dividing gross revenue by net revenue. A higher gross margin means that the firm does not have to pay a lot of money to make the goods that it sells. The second type of margin worthy of mention is profit margin. This measure is the difference between gross revenue and expenses. This is an important measure because it tells how profitable a company through a signal statistic. For example if a small business has a profit margin of 1%, implies that expenses are very high and small changes can be the difference between profit and loss. The final type of margin is contribution margin. Contribution margin tells the profitability of each product or service line. In order to calculate the contribution margin for a product or service take the sale price and divided by the related costs. This figure is usually an eye opener for organizations. For example, I contributed to an analysis project for an organization which revealed that one of its services was actually losing money with each sale. This situation is actually quite common as many organization add on new services\products without assessing the cost to bring it to market.
Know Which Buttons to Push
Every business owner should know what actions to take in various business situations. In many industries this is referred to as disaster recovery. Disaster recovery is a set of procedures to be followed in the event of natural or human-induced disaster. The typical business encounters events every day that can have disastrous effects on a company’s bottom line and future. A small business owner needs to know which actions to take when certain events take place. For example if revenues fall by 10% due to a new local competitor should prices be cut, overhead reduced or should the same practices be maintained. Each of these steps has a different impact on a business’s profit. The decisions must be well thought out, and a mastery of the numbers is critical.
Bench Mark Common Measures
One of the best ways to master your small business numbers is to compare your business to peers and industry norms. Comparing a small business to counterparts can give a small business owner a sobering reminder about its true state and potential. For example, according to the Risk Management Association the typical gross margin for an educational services institution is 59%. Firms that fall below this number now have a target to try to reach. Firms that have higher gross margins are empowered knowing that they are ahead of the industry standard.
Many small business owners started their companies as the result of passion. However, passion is not enough for the long term stability of a company. A strong understanding of the numbers is vital to making the proper strategic decisions. The points outlined in this paper will help business owners begin the path to financial mastery and business growth.