By Abe Sherman, CEO BIG
During a year-end planning meeting with our accountant in late October we were reviewing our financials (as we do nearly every month), working through revenue, expenses and cash flow in order to plan for next year. I mentioned that to me, growth for the sake of growth isn’t interesting, but that our long-term strategic plan is to continue to build our team with the right people in order to deliver additional services that our clients and industry need. Not only finding the right people from a skills standpoint, but those who fit our company culture; that is how I choose to plan instead of chasing top line revenue growth.
I mentioned to him offhandedly (regarding growth) that we work with jewelers who have very impressive top line sales (significantly north of $10 million) with very low net profit as well as challenging cash flow, to which he simply said: “Vanity, Sanity & Reality”.
Say what? He then explained, Vanity is top line sales, Sanity is Net Profit and Reality is Cash Flow. I just sat there absorbing that for a few seconds… It’s brilliant! He said he couldn’t take credit for it but heard it from a very successful client of his in the manufacturing business. Brilliant.
So, how should you be thinking about how top line sales, net profit and cash flow are related? If you are thinking about sales without considering changes in your gross profit % and expenses, then you’re probably not focused on your net profit. Sales growth can occur and gross profit can drop – at the same time! Shocking, I know.
And if you’re not constantly thinking about managing your inventory, you’re probably not thinking too much about cash flow. Some people are fortunate and don’t need to worry about these things because they built a successful company without these challenges; having enough cash to pay their taxes and vendors, including the bank. But if you are among those who scramble to figure out how to pay your bills, read on.
How should we be thinking about analyzing the three main areas of our financials: Sales, Net Profit and Cash Flow? “Sales”, as our top line, can be somewhat misleading because most people develop their expense budgets off of Sales. For example, if you determine your Marketing Expense as a percentage of Sales, take a look at how much all of your marketing expenses are as a percent of Gross Profit. Go ahead and look… I’ll wait here….
You can plan for a sales increase, spend more in marketing, have a decline in gross profit and just have your cash flow crushed. Such is the nature of using top line sales to plan your expenses.
Your biggest “expense” in effect, is the cost of the goods you sell (COGS) and the higher that number is, the lower your gross profit is, leaving you with fewer dollars to pay your other expenses, including taxes. It is one thing if you don’t want to pay taxes, no one does, but it’s another thing if you can’t because you haven’t the cash available.
It is, of course, perfectly fine to think about revenue, but if you’re not also considering your gross profit and expenses, then it becomes a conversation about Vanity; about sales, not about your bottom line or about cash flow. Take the ridiculous example of selling everything at cost. It won’t matter what your sales are – you’re only going to be able to pay for your inventory with zero left to pay all other bills! Because it costs money to run the business, those expenses usually get paid each month but if there isn’t enough left to pay for inventory, your debt (trade or bank) goes up… and up.
Expense budgeting is driven by sales, as I’ve talked about in previous articles. But consider flipping your Income Statement upside down. Don’t look at it from the top, Sales, look at it from the bottom, Net Operating Income. Your goal on the Income Statement is to be able to generate a profit. If your goal is to increase your net profit, try analyzing every line item for how to shave your expenses in dollars, not by percentages.
Your goal on your Balance Sheet is to have plenty of cash on hand to pay your taxes, accounts payables, bank loans and of course, yourself. Ending cash is a function of how much gross profit dollars you are able to generate, what your expenses are and then how much inventory you are going to end the year with. Here’s my question: Do you have an ending-inventory number in mind for 12/31?
Bottom Up vs. Top Down
The two things we addressed here, net profit and ending inventory, are typically dealt with at the end of the budgeting process. I would like to suggest you flip them and plan for your net profit first, keeping this past rolling 12-month’s sales as your going-forward sales number. I can’t tell you what the next year is going to look like, so forward looking forecasting is little more than a guess, and as a practice, I avoid this method of planning. However, using rolling 12-months, you can see where you are now, and plan from here.
To improve your gross profit dollars, you have four choices; sell more, raise your prices, discount less or change your merchandise mix to include higher-gross profit inventory. From that gross profit, you are going to pay all of your expenses, with plenty (hopefully) left over to put to the bottom line.
The problem we run into when doing our analysis, is that most people use their top line sales number to create their expense budgets. But when you look at your Income Statement from the bottom up, you’ll be in the position to decide how much you want to improve your net profit; one expense category at a time! It’s this combination of having gross profit and expense goals that change the nature of the planning process.
Reality – Cash Flow
Determining your ending inventory far in advance (like now), causes a number of things to be considered simultaneously; inventory planning, reordering, stock balancing, re-merchandising, sales promotions, clearance showcases, breakups, donations and melt. You simply can’t achieve these goals if you start working on it next November! Remember one thing – your inventory didn’t get to look like this overnight, and you won’t be able to fix it overnight. It takes months to get your inventory under control, if not years.
You may have a great year – from a sales perspective. But if you keep growing your inventory, don’t have enough gross profit or are spending too much, your cash flow is still going to be a challenge. You can fix these things by planning for them, and we’re here to help.
Top Line Sales, Net Profit, & Cash Flow = Vanity, Sanity & Reality