Biz Math 101 – Profits Biz Math Basics

Biz Math 101

 

Business math 101 is so simple we can cover it in a few paragraphs. You buy some raw materials and throw them together, or you buy at a good price, and you sell the end result for more than you paid for it. Hopefully, much more. That extra is called Gross Profit. You then pay for a whole heap of things that you never imagined existed, and these are called expenses. Again, hopefully, you still have something left, and that’s called net profit. Actually, it’s net profit before tax because now the government demands a share. What you finally have left is called net profit after tax. You decide how much you want to retain in your business to help it grow, and how much you want to distribute to shareholders (usually just you!)

 

Let’s Set an Example:

 

Now let’s put some numbers on it. Start from the back end. Let’s assume you want around $50,000 per year for your own needs. That provides a reasonable lifestyle in Bali as well as an amount to put aside for a rainy day and some travel in your well-deserved holidays.  This part is called Owner’s Draw. And let’s assume you need to put the same amount into funding your business growth. You need to ensure that you have funds to replace your technology and to invest in productivity improvements and new capital equipment or refurbishment.  This is called retained earnings.

 

So we are at 50 + 50 = $100,000 after tax. At this level of business income (ie net profit) you are at the full tax amount which is 25%, so you profit before tax will need to be $100,000 / 75% = $133,000

 

Owner Draw 50,000
Retained Earnings 50,000
Net Profit After tax 100,000
Tax (25%) 33,000
Net Profit Before Tax 133,000

 

If your average net profit amount is 20% of sales then your sales (revenue) will need to be $665,000

 

If your net profit is 25% then your sales will need to be four times net, or $532,000

 

Let’s assume your gross profit margin is 50%, so your Cost of Sales or Cost of Goods Sold will be half of your sales – $333,000 at 20% Net or $266,000 at 25% net.

 

We are talking a need for a markup on your cost of sales of between 2.7 and 3.3 times to get the end result of $100,000 clear.  (If you are achieving a markup better than this then great, assuming your expenses are not eating up that additional profit.)

 

Net Profit before Tax  133,000
Net Profit Share of Sales 20% 25%
Sales Equivalent 665,000 532,000
Gross Profit (50%)  332,500 266,000
Cost of Sales 332,500 266,000
Markup Required 3.3 2.7

 

We can draw some conclusions from these figures:

 

  1. Sales are not nearly as important to measure and improve as is net profit.
  2. Pricing strategies that grow your bottom line without having to increase sales volumes are enormously attractive. A direct 5% increase in net profit reduces your need for sales by over $100,000.
  3. You could reduce your need for retained earnings by borrowing capital – but you still need to factor in loan repayments – interest and capital.
  4. You could reduce your need for Owner Draw by paying yourself a salary at a tax rate much less than the 25% company tax rate. In this case, expenses go up a little and the need for Net Profit goes down a bit more.

 

So that’s biz math 101.  Pretty much everyone focuses on it, but it’s the start, not the finish.

 

Biz Math 102 – Working Capital

 

Business math 102 considers survival and growth. It’s about cash flow. The best cash flow measure to help you know your liquidity position is dividing your Operating Cash Flow (from your financial software Statement of Cash Flows) divided by your Current Liabilities (from your Balance Sheet.) You need a ratio of better than 1 or you are facing major problems.

 

Also, examine your working capital.  What is working capital? It’s the money you have tied up in the business on a short-term basis, the money that makes the big wheels go round. How well you handle this can simply make or break your business. Handled well, it is the bedrock that your business growth is based on.  If your working capital management is poor then at best you will be making expansion much more difficult, at worst it will bankrupt you because you suddenly find you can’t pay your suppliers.  A time of rapid growth is the most dangerous time for business survival, but at any time of growth, you most need to pay attention to your working capital.

 

Working capital has three elements, Accounts Receivable (what others owe you), Inventory (raw materials, work in progress and finished goods) and Accounts Payable (what you have to pay out to others)  All of these involve cash – money owed to you and inventory are assets, and money you owe to suppliers is a liability.   The difference between these assets and liabilities at any point in time is your working capital.

 

Working capital performance is one of the most important metrics for assessing your business health and efficiency. Days Working Capital (DWC) is the number of days it takes to convert working capital into sales or revenue. On average, top performers have 49% less working capital tied up in operations. They collect from customers about 2 weeks faster, pay suppliers about 10 days slower and hold about half the inventory of a median business. These companies are more resilient to changes in their environment and they are better placed to take advantage of market opportunities.

 

Typical Retail Business

 

In a typical retail business here you could look at best practice benchmarks of 6 DWC in Accounts Receivable,  120 DWC Accounts Payable if goods are being made to order for you, 60 DWC otherwise, and 50 DWC in Inventory.  Very few people are achieving these numbers.  In the Biz Doctor app, we list nearly 100 actions you can choose from for improving your working capital position, obviously too many to list here.

 

If you are in the main cash business such as retail, then working capital in Accounts Receivable is pretty negligible. If you are in wholesale or manufacturing then you are dealing with invoices and cash collection over an extended period and so working capital for Accounts Receivable takes on a whole new meaning. You can look at a range of strategies to reduce your DWC here.

 

Inventory is one area that can quickly absorb all your spare cash, especially when you are in a growth phase. In one wholesaling business in Australia, we reduced inventory by $2 million and yet improved customer service from an average 60% to an average 90%. In two Bali businesses, I have worked with we were able to halve inventory in each, in one case by $50,000 and in the other by $30,000. This is a substantial amount of cash to free up in anyone’s business, but there’s more. At the same time, a re-balancing of inventory increased availability for sales from an average 65% of items, to 95% for top sellers, 90% for B Category and 80% for slow movers. You build your business from supply reliability; having top-sellers out of stock can severely hamper your growth and damage your brand.

 

Accounts Receivable –

What you have to pay out – is often just a matter of setting business rules. Then making sure they are followed. You need to be careful with your key suppliers, many of whom are operating on restricted cash flow also. So that you don’t starve them of cash to be able to give you supply reliability in turn.

 

If your business is large enough, you should make someone responsible for working capital. It’s not a full-time job but should be treated as a priority. This is the person that follows up customers for payment on time. The person who ensures purchasing agreements uses standard clauses. And that you are not giving money away too early. This is the person who gets reports on inventory levels to analyze and look for potential savings. This person needs business rules to follow (that you set.)

 

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