‘Administration and Finance’ is Pillar number 4 for small business success.
If Business Fulfillment is the engine room of the business, then Administration and Finance is the plumbing. If it’s not done right, you will end up in a mess.
In the administration and finance pillar we have all those things that are so necessary, but many people find so boring. Things like:
It is no secret that most small businesses are ‘strapped for cash’.
A Forbes article titled ‘Why Entrepreneurs Fail: Top 10 Causes Of Small Business Failure’ by Stephanie Burns’ lists “ran out of cash” as the number 2 reason for small business failure, affecting 29% of failed businesses. (This article uses the post-mortem study of 101 business failures by CBInsights referred to earlier.
In my experience, cash flow problems are a major issue for most small businesses. That is why it is so critically important to only give credit when you absolutely have to, and to chase up customers who owe you money and exceed your credit terms.
In the Nov 16 issue of Entrepreneur magazine, Eyal Shiner declared that the 26 million self-employed small business owners in the United States are owed an astonishing $825 Billion from outstanding invoices, and a US Bank study revealed that poor cash flow management is the cause of 82 percent of small businesses failures. (You can read more here.)
Having systems to ensure you are being paid by your customers is critically important.
We looked at cash flow first because it is the life-blood of your business. It is the most critical survival factor to manage on a daily basis.
For longer term survival you have to make a profit.
Profit is what’s left over when you take all your expenses away from your income, and by and large, profit is what you pay tax on.
It is different to cash flow, because not all money you receive is ‘income’ and not all money you pay is an expense.
For example, a loan from the bank, or when you put money in from your private resources is not income. Similarly, making loan repayments and buying equipment are not expenses.
Your business needs to make enough profit to allow you to repay loans and meet your personal expenses.
It is important for every small business owner to have an understanding of business finances, so you can track and monitor the health of your business. A good accountant / business adviser will also be helpful.
It starts with keeping your financial records up to date. This allows you to regularly analyze your finances to track and manage your margins and costs.
You can check the health of your business with financial ratios that help you to detect potential problems early so you can make changes, and also compare your business to others in your industry.
We outline some of the key ratios below, but first let’s look at another reason why your ‘back office’ is so important.
Government compliance effectively means complying with all the legal requirements of running a business, including various local, state and federal laws.
You are required to pay income taxes based on your income and expenses, and you need to keep records to substantiate your calculations. You need to keep such records for up to 7 years (depending on the requirements for your country) and even longer in relation to assets and loans.
There are often other taxes, such as sales taxes where records must be kept.
There are licenses, health and safety policies, practices and inspections, that all require records to be kept.
You need to keep records that enable you to report to the government and substantiate that your reports are accurate.
Not complying could potentially leave you exposed legally, open to costly penalties, and put your business at risk.
As your business grows and you take on employees, you then have other responsibilities in relation to keeping employee records. This can incorporate employee agreements, rates of pay, leave entitlements, timesheets and more, as well as performance reviews, interview records and so on.
So in summary, this part of the business can be overwhelming, and while it might be boring and take time away from doing work that brings money in, proper attention to administration and finance is essential to business survival.
In the section on Leadership, I mentioned Michael Gerber, the author of ‘The E-Myth’. The sub-title of that book is ‘Why most businesses don’t work and what to do about it’.
Michaels’ answer is that the system is the solution. Everything needs to be systemised to a level that anyone can do it.
Thankfully we live in an age with systems all around us. There are systems for almost everything:
The trick is to find the systems that are right for you.
One of the major benefits of being a member of the Self Employed Business Academy is the Community Forum where members can communicate with other business owners about business issues they face, including feedback on systems you may be considering.
The truth is that for most self-employed people, all this back-office stuff is a chore they do not enjoy and often ends up being a major cause of stress.
So for many, this is the first area where they look for help, either in the form of an employee or by out-sourcing.
While this can be a great decision, it is important that you, as the business owner monitor this carefully. After all, it is your money, your business and your life.
It is also very helpful to have an understanding of the financial information and what it means.
We talked earlier about using Financial Ratios to analyse your business finances. Here are some ratios that will help you.
How much do you need to sell in order to break even – where your income equals your expenses, so you begin to make a profit?
Without over-complicating this, your overall break-even point is calculated by dividing your fixed costs by your gross profit margin.
Breakeven Point = fixed costs/gross margin
If your fixed costs (expenses) are $10,000 and your gross margin is 60% then the sales you need to make to breakeven are $16,666.
A margin shows you what percentage of each sale is profit.
Margin = ((sales – cost of goods sold)/sales) x 100, or
Another way of looking at it is Margin = (profit/sales) x 100
Gross Margin simply means you are comparing total sales and cost of goods sold as distinct from individual products.
The percentage you add to the cost price of a product, to arrive at your selling price is the Mark up.
Mark up = ((sales – cost of goods sold)/cost of goods sold) x 100
Another way of looking at it is Mark up = (profit/cost of goods sold) x 100
People often get these terms confused.
The difference is that Margin is calculated by dividing profit by sales whereas Mark up is calculated by dividing profit by cost. The mark up % will always be higher than the margin %.
For example, if the cost of a product is $10 and you sell it for $15, the mark up is 50% whereas the margin is 33%.
Margin = (($15 – $10)/$15) x 100 = 33%
Mark up = (($15 – $10)/$10) x 100 = 50%
When you look at your Profit and Loss (Income) Statement, you will see that your Gross Profit is equal to your sales less the cost of goods sold. Other business operating expenses are then subtracted to calculate your Net Profit.
This is the percentage of overall sales that ends in gross profit.
Gross profit margin = gross profit/sales x 100
This is the percentage of overall sales that result in profit after deducting business operating expenses.
Net profit margin = net profit/sales x 100
This calculation measures the number of days it takes to collect the cash from sales on credit. The longer it takes to collect the cash, the more cash flow problems you are likely to have, and the more likely that you will have bad debts.
Accounts receivable (Days) = Accounts receivable/ sales on credit x 365
Note: financial statements do not usually show sales on credit as distinct from total sales. You will need to look at your bookkeeping records to make this breakdown.
This calculation measures the number of days it takes to pay your suppliers for good purchased on credit. Making use of supplier terms allows you to use money in other areas of the business. However, extended days will be an indication of the business struggling to pay its debts and can result in a poor credit rating.
Accounts payable (Days) = Accounts payable/cost of goods sold x 365
This is an efficiency ratio that measures how effective you are at turning over your inventory. It shows how many times a business sold or ‘turned’ its average inventory.
The higher this ratio is the better as it indicates how long inventory is being stored.
Inventory turnover = cost of goods sold/((opening inventory + closing inventory)/2) x 100
There are other ratios that your accountant or business adviser may review with you, but these ratios are a good starting point for managing your business.
Ratios differ across industries. However, you get a reasonable idea as to how your business is performing by comparing your financial ratios to a benchmark for businesses in your industry.
A site providing comparative ratios for US businesses is BizStats. In Canada, you can find financial performance data at https://www.ic.gc.ca/eic/site/pp-pp.nsf/eng/home. In the UK, you can try Nibusinessinfo.co.uk and in Australia, you can try https://www.benchmarking.com.au/ or start with the Australian Taxation Office Small Business Benchmarks that are calculated from tax returns and activity statement information.
Now that we have reviewed the various foundational pillars of business, let’s look at how we use this information to survive and actually thrive in our own business venture.
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