High Profits & About to Crash?
A relevant question for SME Management.
“How important is profit?” this question in one form or another is one of the most common questions we receive from new SME owners or potential start-ups and surprisingly it’s not a simple one to answer.
Some time ago I sat down for a chat with a highly intelligent friend who had recently joined the board of a mid-sized family SME. “I just don’t get it” she said “everyone tells me the business is booming, sales are up, profits are up yet from what I read the company is broke”.
My friend had sat down with the half year results and looked at the first two quarters performance against budget. Revenues were up by around 35%, Gross Margin was tracking, as a percentage, around 5% better than budget and operating expenses were around 11% lower than budget leaving a very healthy EBIT compared to budget and management applauding themselves all round.
Where is the problem? I hear you ask.
Cash or rather the lack of it was the problem. As revenues and revenue projections grew the funds allocated to the raw materials and finished goods needed to service such growth had increased exponentially as had the debtor’s ledger.
Yes the SME was producing more at lower cost and selling every item produced at a profit but amongst the excitement no one had calculated the impact on future cash flows.
If you achieve an EBIT of 20% (which is on the generous side) it means you have to outlay costs, in advance, of at least $0.80c in every dollar of anticipated revenue. You may offset this to some extent by negotiating an extension to trading terms with your creditors but that is a very slippery slope and best avoided.
If you sell your product to a major retail chain, they will look to pay you in 60 days from the end of the month in which you invoice them. So you could easily wait 60 to 90 days for payment. For every $10 of widgets you sell them each month your cost is $8 and if you carry that and the subsequent monthly sales until you are paid, you are out of pocket by $24 before you receive a cent. On top of which you have had to lift your finished goods to 60 days stock to meet varying demand and raw materials by 45 days so you are roughly $50 out of pocket as you wait for the $10 to be paid of which you retain $2 profit or EBIT.
Yes you are still profitable but your short term cash burn is exceeding income and without a rethink your fast growing, profitable enterprise is going to crash.
My friend could see where the company was heading whilst the sales manager was elated by high revenues, the production manager proud of the COGS and the operations manager satisfied by the low level of OPEX. In all business management not just SME’s good cash flow management and budgeting is essential.
There were several funding options available to secure this company’s future once the threat was identified. But within 60 days the company may have been in turmoil and no funder wants to lend into a panic.
So in answer to the question; profit is very important but it is just one of what I call “The Four Pillars of Business”: Revenue, Cost, Profit and Cash; and always remember that whilst the first three are very important CASH IS KING.
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