When expenses and costs compared to sales revenues yield a profitable result, your business is in financial balance. If this is not occurring, the equation is unstable; it’s either too high in overhead and expenses or too low in revenue, or perhaps a combination of both.
Understanding the equilibrium of your business begins with an accurate presentation of the current operating cash flow proforma. When you can see your sales projections as well as the overhead and operational expenses, you can assess your financial condition month by month—as money comes in and as it goes out.
What’s the objective?
The objective of the proforma is to create a better business model so that you can increase revenue and, thus, profitability. In most cases, adjusting both sides of the equation (money earned versus money spent) is necessary. Therefore, creating equilibrium is really accomplished by a combination of the following:
- Fine-tuning the sales and marketing efforts with systemic changes to yield higher revenue. This may involve reductions in current spending or additional investments to produce better results.
- Reducing expenditures so that overhead supports a lucrative income stream.
Before it’s implemented in real time, the proforma will tell you if the adjustments you’ve made still don’t yield adequate profitability, in which case you can assess each line item one at a time until you’ve achieved that goal.
What comes first?
Let’s examine what it looks like to implement this approach. Say the proforma indicates a negative operation for many months or even for the entire year. Ask yourself the following questions:
- On the expense and overhead side of the equation, are there any Key Performance Indicators (payroll, rent, marketing, cost of goods, etc.) that are out of balance–meaning more expensive than the revenue can support or in excess of industry standards?
- Can these be adjusted appropriately to reduce expenditures and thus amplify profitability?
- On the revenue side, can the sales and marketing effort be expanded or adjusted operationally, either by investing more resources or changing the sales and marketing program?
- Is the product or service priced profitably?
For many businesses, sales revenue tends to peak at some point in the year and decline at others, drastically altering the overhead/revenue balance. Fortunately, these seasonal swings are largely predictable, which means you can plan to increase inventory or decrease payroll to maintain a stable balance sheet through the highs and lows.
What are the most important line items to examine?
Once you’ve got the answers to the above questions, you can begin a deep dive into the line items on your balance sheet.
- If payroll is above the standard for your industry, reducing it will have a direct impact on your bottom line. Payroll for most businesses should be between 30 and 40% of gross revenue.
- Reduce rent through by negotiating a decrease or moving to a lower cost facility.
- Reduce the cost of goods or services.
- Invest more in sales and marketing.
Often when you follow the steps above, you immediately see a shift towards profitability and balance. If those changes haven’t yielded enough of a profit increase, you can try the following:
- Add more salespeople.
- Redefine the commission equation, emphasizing the creation of new business, and reducing the rate for repeat business. Decreasing base pay and increasing commissions on first-time clients forces new business.
- Eliminate the production or delivery of low-demand goods or services.
- Change how sales are made, what the sales funnel looks like, and how it works.
- Market to an expanded or redefined market. You can do this by adding women to an all-male target market–and vice versa–or by increasing your territory. Geographical growth can be achieved by attending trade shows; you’ll spend more but yield more, creating balance because you’re getting a better result.
- Make improvements to the product line or services, with an eye toward controlling expenditures and increasing revenues. Add a high-end option, enhance quality or offer a better guarantee.
- Unload excess inventory.
- Limit your product line to the best sellers.
- Decrease your workforce. Most business owners think they can’t operate with fewer employees. However, cutting staff simply challenges the remaining employees to be more productive. Adding incentive rewards for reaching specific goals is an excellent method of getting the most out of your workforce.
Balancing the overhead/revenue equation is more about creativity, intuition and vision than it is about simple math. It’s a dynamic process with many moving parts. Successful planning requires imagining appropriate and effective adjustments and then implementing and assessing them.
Other Methods to Increase Profit
Frequently the only way to add value to the sales and marketing side is with greater investment. If inadequate capital prevents such measures, reallocation of funds can occur once expenses are reduced. The following efforts may also have a positive impact on the business equation:
- Marketing directly to the consumer on the internet can yield additional profit and higher revenue when combined with your wholesale marketing.
- Reducing the cost of the materials used to produce the product by collecting bids and getting suppliers to compete for better pricing.
- Increasing sales prices to yield a greater profit without increasing gross revenue. The idea here is that when sales do not generate adequate profits, greater revenue actually deepens the loss. An example of this scenario is when a company offers free shipping, which may attract more buyers but negatively impacts their bottom line. Net 90 terms are another situation that can do more harm than good: until your clients pay, that money doesn’t count, and you need to have adequate cash reserves to compensate.
The objective, then, is to increase net profit, not just gross revenue. When balancing the equation between expenses and income, the liquidity—or availability—of cash is a crucial consideration. A large amount of money tied up in inventory that only turns once a year, for example, will destroy balance. Accounts receivable collections over net 30 do so as well, creating a need to only sell to clients who pay on time. Innovating ways to do this requires visionary thinking. And as you can see, meticulously projecting the receipt of accounts receivable is crucial to creating an accurate cash flow proforma.
Trying to predict the future to the best of your ability is key to running a thriving enterprise. The cash flow proforma is the crystal ball that helps you do this. Managing your balance sheet requires diligence and constant refining. The beauty of this tool is that adjustments can be made each month in real time so if your changes aren’t yielding the desired results, you can pivot immediately.
If you need support setting up your proforma or want to strategize ideas for improving your cash flow, Second Wind can help. Contact our team today for a consultation.