A certain service business, clawing its way to $5 million in revenue during 14 tough years, was barely turning a profit or providing a reasonable wage to the owner. That’s when Greg Crabtree’s accounting team stepped in and, using Crabtree’s “Simple Numbers” approach, helped the owner see his business in a different light. They made gross margin their key top line instead of revenue. The service firm adjusted the owner’s pay to a real market wage so that profits would not be overstated, and Crabtree’s team introduced techniques for tracking labor efficiency, which helped the owner align his labor costs immediately with business cycles.
The net result was this: Crabtree’s client grew to $25 million in the next five years and hit 10% profit after paying the owner a competitive salary. Yes, there were significant taxes to pay, but that’s because the company was now generating real after-tax wealth that helped both the business and its owner become debt-free and flush with cash.
In the upcoming series, we will explore the pillars of Crabtree’s “Simple Numbers” formula and break down the process that has helped hundreds of business owners improve their profitability dramatically. One of these pillars is understanding the four forces of cash flow.
The 4 Forces Of Cash Flow
Once a company is on the road to 15% profitability, as defined by the “Simple Numbers” formula, it faces additional cash flow challenges. We say “additional” because whenever management tells us there’s a cash flow problem, we always start with fixing profitability, unless the company is broke and needs an immediate cash infusion to make payroll.
You can improve cash flow by negotiating favorable terms with customers and vendors. However, we recommend sacrificing your margin with special deals only if you’re desperate.
Force No. 1: Taxes
You need to know how much you owe in taxes throughout the year to avoid the annual Tax Day surprise, and you must resist the temptation to spend $1 in order to save 40 cents in taxes by rationalizing, “Hey, the government pays for 40% of the cost of the computer (or whatever the company is buying), anyway.” Crabtree believes that rather than chasing the very limited tax-saving maneuvers available, certified public accountants would better serve business owners if they would emphasize that true wealth is created only with after-tax profits. If you do not pay any taxes, you either have not created any wealth or you have cheated, and both scenarios are bad.
Force No. 2: Manage Debt
Debt is generally not your friend. If not managed properly, debt will enslave your business and keep it from reaching its full potential. Once you have set aside your tax money, eliminate debt on your line of credit and remain current on any term loans. Lines of credit are addictive for businesses because it’s too easy to draw on them to solve cash flow issues rather than make the hard decisions that lead to improved profitability.
If you need a line of credit to handle seasonal ups and downs or to extend your customers’ credit, we recommend that you borrow on it only when you are profitable. If you are losing money, do not draw on it before you fix the underlying problems. Banks know that a company losing money will eventually have no funds to repay the line of credit.
Term debt can help you spread the cost of long-term assets over their useful life. However, if you have “termed out” your line of credit, pay off this debt as quickly as possible if it does not support any long-term functional asset. You must avoid falling for the trap of using debt to buy an asset at year-end just to save on taxes. This ends badly over the long run, unless the asset is critical to improving profitability.
Force No. 3: Core Capital Target
Meeting your core capital target means having two months of operating expenses in cash after you have set aside money to pay your taxes — and assuming you have nothing drawn on your line of credit. In our opinion, any company that can meet this criterion is considered fully capitalized and can start harvesting profits for either further growth opportunities or distribution to shareholders for wealth diversification. If business owners harvest profits before debt is cleared, they risk putting the business into an undercapitalized situation. This is a problem that plagues many growth companies.
The definition of two months of operating expenses includes all normal operating expenses on which you do not get terms. As a rule, the only costs you exclude will be your cost of goods sold, since businesses typically get terms of 30-plus days.
Hitting the core capital target is one of the most rewarding accomplishments we have seen our clients achieve. It changes their thinking and improves their profitability. They are not so cash-strapped that they have to give away margin, and it gives them staying power through a bad quarter. Most of them never want to see line-of-credit debt again.
Force No. 4: Harvest Profits By Paying Dividends
Once you have set aside taxes, paid off your line of credit, and met your core capital target, you can safely take your after-tax profits in the form of a distribution or bonuses to employees. You have now created a profitable, cash flow-generating business — the best of both worlds. The company is more valuable than less profitable peers. You own a wonderful, high-performing asset that you may want to consider holding onto rather than selling.
Here is the often-overlooked nugget in all of this: If you run a business at 10% profit that has hit its core capital target, you now have a business that is producing a minimum return on equity of 50% per year! Investors would kill for a rate of return of 20% year after year, and yours is running somewhere between 50%–100% per year. This is the true secret of building wealth within a privately held business.
The key is getting a better handle on a few crucial ratios and adjusting your numbers to get a better picture of your true profitability.
