Tom and Alexis Leonard had dreams to be entrepreneurs. However, like most people, they were stuck at a point in life where they needed to live off of both of their incomes. Tom was an engineer whose job had little flexibility. Alexis worked from home as a sales rep for a wine distributor. After the couples second child went to school, they realized that with the kids at school and some of the flexibility in Alexis’s job, they might be at an opportune time to start a franchise. A franchise gave them the support they needed since neither could dedicate 40 hours or more a week to the venture.
After looking at several options, the couple settled on opening a salon that had over 200 locations across the United States. The opening support was very well refined and as part of the process, the couple went through several exercises to determine their budget, return on investment, and several other key financial goals.
The couple was realistic about their financial goals. They knew that for the first 18-24 months, there would be very little profit. Any profit the business did generate would be put back into the marketing efforts or go to paying down the small amount of debt the couple had taken out to start the business.
In the beginning, things were done on a shoestring budget. The couple did all of their own marketing, human resources, and accounting. The duties the couple took on began to pile up and as such, certain tasks were delayed and sometimes not completed. Many of these tasks were related to bookkeeping. As the store grew, the couple incurred more and more expenses to support their growth.
Two years after opening, Alexis got word that a salon approximately 8 miles away from their current location would be going out of business. Sensing an opportunity to expand into a location that would require little capital to convert into their current model, the couple jumped at the chance to open up a second store.
While both stores were successful, the tasks to support them only grew. Alexis slowly transitioned into more of a part-time role in her sales job so that she could support the two stores more.
Business is Great…But Where is the Money?
Three years into the venture, most outside observers would call it a success. The two stores continued to grow each month, albeit some slower than others. While labor was an issue for many salons, Alexis had been able to create a culture that many wanted to work in. Further, she was able to design a compensation structure that paid the stylists more than many of her competitors.
Alexis also had integrated herself into the local business community. Along with being a member of the local Chamber of Commerce, she was on the board of a local business group devoted to women entrepreneurs. From all outside indications, the business was thriving.
However, 36 months after starting, the couple had withdrawn little money from the business. While their books were not in good order, they thought they were good enough to get a good read on the business. However, neither could see where cuts needed to be made to grow profit. For the amount of work Alexis and Tom were putting into the business, they thought there should be more profit to be withdrawn from the business.
This Is Not Unique Problem
Despite the staggering odds that are often portrayed, 50% of businesses survive more than 5 years. However, the vast majority of these businesses struggle with profitability. In 2018 more than 86% of business owners said they took home less than $100,000 from their business. While that might not be too alarming, it should be eye-opening that 30% of small business owners don’t take home any money at all from their business.
Think about this for a second…..78% of business owners say their business is profitable, however, almost half of those are not taking home any profit. Where is it going? If these businesses are so profitable, why do 33% of business owners say that lack of cash flow is their top challenge?
To be blunt, most business owners don’t have a good idea of where their businesses are financially. Most business owners manage cash flow by reviewing their bank account on a daily basis. If there is money in the account, they feel good and make plans to spend it. If there is no money in the account, they make plans to get more. None of this “cash management” is done with an eye on expected cash inflow or outflow in the coming weeks or months.
This is not just an opinion. According to SCORE, 82% of businesses fail due to poor cash flow management. Most of those that responded to the survey said they did not categorize spending, benchmark their expenses or exercise management over their spending. Almost none of them forecasted their cash flow or budgeted regularly.
This should not be a surprise to many. Most of what is going on in the management of business finances is mirrored from the management of personal finances. According to a study from the National Endowment for Financial Education, only 24% of people demonstrate basic financial literacy. Half of American households live paycheck to paycheck. While managing personal finances is hard, it is even harder to manage the finances of a business.
Armed with this information, why do only 25% of businesses use a CPA or bookkeeper? Most would say it is an issue with cost. However, if the alternative is going out of business or not taking home a profit, is cost really the only thing standing in the way?
Putting Together a Plan for Profit
Tom and Alexis use a CPA once a year to clean up their books and compile their tax return. The work the CPA did on their books was merely to clean up the income statement from the prior year, make sure expenses were somewhat properly categorized, and look for specific items that would impact the tax return. Tom and Alexis somewhat assumed that if things looked off to the CPA, he would speak up and say something. However, the CPA’s goal was merely to file their tax return.
In April of year four of owning the business, the CPA told them they would need to write a check for $16,000 to cover their taxes. The couple was in shock. This was approximately as much as they had withdrawn from the business in the prior year. Alexis delivered the check and thanked the CPA for completing their tax return. Sitting down over a glass of wine that night, the couple reviewed the financial statements the CPA had completed. Where was all of the money going?
Alexis confided this story with the owner of a second-hand clothes store next to one of their salons. Shortly after, this is when I met with Alexis and Tom and learned of their story. At that point, we decided to come up with a profit plan to help them realize the potential of their business.
1. Budget for Profit
After review the couple’s books, there was no reason the business should not be more profitable. In doing some benchmark analysis (comparing their income statement to other like businesses), we were able to determine benchmark profitability. I had the couple open up a second bank account called their “Profit Account”. At the end of each week, we transferred over a certain percentage of the cash receipts into the profit account. The percentage was the same each week and was transferred over no matter what.
To start, we moved over 10% of cash receipts. In addition to this, we moved over 10% more of cash receipts for taxes. We would continue to tweak this as we learned more, but this was our starting point.
2. Budget the Rest
After budgeting for profit, we knew that approximately 80% of our cash receipts would go to cover expenses and debt service for the business. This gave us a ballpark number to start from in determining our operating budget. Tough choices had to be made. However, this is what the business could afford and as such, expenses that benefited customer services were prioritized. There was no room for frivolous expenditures and at times, we had to get creative to cut costs but still have the salons provide great service to their customers.
Let me stop here and say, this isn’t an easy process. Owners must buy in and make tough decisions. While I only dedicate a paragraph to these steps, know that the execution and strategy are much more encompassing.
3. Forecast Cash Flow
We created an easy, 6-week cash flow forecast spreadsheet where the couple could easily project out their cash flow. This allowed them to know when certain invoices should be paid so that they did not run into cash flow crunches. Only forecasting out 6 weeks (instead of 9 or even 12 weeks) allowed more accurate forecasts and an easier methodology to follow.
4. Financial Best Practices
Once the initial steps of the plan were put into place, best practices were instituted to make the business more financially sound. This included starting to look at payables and factor in the two stores cash gap to better manage cash. It also gave Alexis insight into her income statement unlike she had ever had before so she could actively manage costs.
A Happy Ending
A happy ending is sort of a farce…..financial management over a business never ends. Never the less, Alexis and Tom were on pace to withdraw more from their business than ever before. Further, the business was primed to grow because now time and effort could be spent on marketing and customer service.
I would be remiss if I didn’t revisit an earlier point of the article. Why don’t more small businesses hire CPAs or financial professionals for help? If the answer truly is cost, how much is it worth to a small business to increase profitability? If these system described above does increase profitability, how much is really being spent on a CPA or bookkeeper?
Another reason may be that sadly, many CPAs, bookkeepers, and financial professionals don’t provide this sort of analysis. Here is some inside baseball….there are a few reasons why. First, a traditional bookkeeper often doesn’t have the background to provide this sort of expertise. While they are great at bookkeeping, they don’t have the training or background to offer controller or CFO level services. While a CPA often does have this background, most don’t like bookkeeping (but none of them tell that to clients).
As a business owner, take the steps above and set up your profit account. If you need assistance, research and find a financial professional that can help you accomplish your goals.
A Final Plug
Of course, I would be remiss if I didn’t mention that Krieger Analytics helps small businesses outsource their accounting needs. We work exclusively with small business owners. Being a small business owner myself, I understand the unique challenges you face. Reach out to us today for an initial call to see if working with us might be right for your business. Phone calls are always free!