As a business owner understanding the financial aspects of your business can be as emotional as it is practical—after all, your business is your most valuable asset. It’s where you spend most of your time, both physically and mentally. It’s most likely a dream you’ve built from the ground up.
One of the most valuable things you can do protect that dream - understanding how to avoid making these common mistakes will improve your business’ financial performance and growth the value of your business.
1. Underestimating the impacts of fixed and variable costs on profit margin
First, let’s define the two costs of operating a small business.
Fixed costs must be paid no matter the volume of products or services sold—for example, rent and other property expenses, marketing and advertising fees, and salaries excluding tips and commission.
Variable costs are directly related to the volume of products or services sold. When sales go up, so do variable costs, and vice versa. For example, raw product materials and production supplies, distribution costs, shipping charges and sales commissions.
To understand the impact each type of cost has on the business, you can calculate profit margin and break-even volume
Profit Margin = Retail price per unit - variable cost per unit
Break Even Volume = Fixed costs / Profit margin
While fixed costs are, well, fixed—that is, rigid and difficult to change—variable costs can often be reduced to increase profit margin. You can consider whether it’s feasible to spend less on raw materials, buy in bulk, and lower distribution costs. You can also implement more effective employee training to increase efficiency.
2. Setting unrealistic sales projections
When business owners set sales goals, in many cases, they are too aggressive. This aggressiveness can create real financial problems for your business by investing in inventory or hiring additional staff to meet demand that isn’t there.
On the flip side, goals that are too conservative can leave the business unprepared for accelerated demand, creating poor customer and employee experiences.
The problem most business owners face with setting annual sales targets is that they follow a framework that’s too simplistic and internally focused—last year’s sales multiplied by an industry-specific growth rate.
This does not account for the very real external variables that also drive buying behaviors (i.e. the economy, supply chain, market trends, even the weather.)
You can set realistic goals by asking these critical questions:
What percentage of my revenue is recurring?
What’s my average customer acquisition cost?
What are my variable costs, fixed costs and profit margins?
How many new customers do I need per month to hit my goals?
3. Mismanaging cash flow
Cash flow problems top the list of reasons small businesses fail—in fact, research shows that 82% of small businesses fail because of cash flow issues. Various factors affect cash flow, including industry and business stage, but one constant remains: A business’s expenses should not exceed its existing cash.
To keep from succumbing to cash flow catastrophes, you need to understand that properly managing cash flow means:
Balancing funding growth with smart, conservative spending
Understanding exactly where cash is being spent
Prioritizing bill payment to protect credit
Closely tracking inventory
4. Maintaining an insufficient emergency fund
Look no further than the events of the last two years to see why you need to prioritize an adequate emergency fund. Having cash reserves in place for slow seasons, unexpected economic downturns, lawsuits, employee illness—the list goes on—can be the difference between keeping your business afloat and closing the doors permanently. Ideally, you should have six months of business expenses saved. You want to understand what that number is, and how to get there.
5. Not consistently reviewing the budget
Typically, small business owners review their budgets annually—when they’re getting ready to prepare next year’s budget. But doing that can mean missing out on subtle increases in expenses, like higher supply costs, and opportunities to reduce variable costs in order to increase profit margin.
Most importantly, what can be measured can be improved. The closer you are to your numbers, the more swiftly you can adjust business processes to optimize for new opportunities or get ahead of potential problems.
Understanding your budget is critical for the success of your owners. You should be reviewing your budget at least bi-annually, if not once a quarter, and make adjustments as necessary.
6. Understanding Valuation: The Ultimate Foundation for Better Business Decisions
Valuation drives every critical financial decision a business owner makes from making additional business investment, purchasing adequate insurance coverage to creating buy/sell agreements to developing a succession plan.
Consistently knowing the value of your business is a powerful way to improve its value. Unlike marketable equities, you are unable to know if the decisions you are making increase the value of your business. If you generate a valuation report every 6 months you can see if your decisions are driving value.
Using the, COSULTING Business Valuation, CEO COSULTING collaborates with business owners to address the challenges in maximizing the value of their business. The 29-page report not only helps you understand the four estimates of value—asset sale, equity, enterprise and liquidation—it also generates critical KPIs and industry-specific benchmarks, so you can see where you stand against your peers, where you’re performing well and where there’s room for improvement.