This article is devoted to the consideration of what is meant by profitability and how this can be maximised. In simple terms the profitability is the net result of revenue less costs.
Costs are a very important part of this equation (as outlined in my last blog). However no business can focus primarily on costs. A product or service must be sold to create an income. Products and/or services must be required by the market place to ensure ongoing repeatable sales. The product pricing then determines the profitability of the business. The price must be set based on the costs, the market requirement, the competition pricing and be consistent with the business’ strategy. So there we have it. The revenue coming in, less the costs gives the business it’s profitability!! Oh for it to be so simple.
A sale has not been completed until the cheque has been received, banked and cleared. Further, true profitability cannot be reported until all suppliers have been paid. And what about all the cash invested in inventory that is required to ensure that delivery times are reasonable and can be met? These factors are your Working Capital and are the significant part of your cashflow. Working capital represents a firm’s net investment in current assets which are required to support the day-to-day activities.
Many organisations give their customers 30 or 60 days to pay. This generally is the expectation for B2B transactions. However, while these payment terms are usually documented in an agreement, don’t expect that all customers will pay on time. Some customers who themselves are under cashflow pressures may push the payment terms out. This means that less cash is available to pay suppliers who also are expecting to be paid on time. One late payment by a customer can have a knock on affect right down the supply chain. The other pressure businesses face is the cash tied up in inventory (if your business is selling products), be that stock on the shelf or goods that are “In Transit”. As most overseas suppliers will not supply goods until payment has been made, this is money tied up in goods that cannot be sold until they arrive and clear customs, which can take many weeks. Again money tied up means less available to pay the bills, wages and the other debts incurred.
How many businesses have their hard earned money tied up in trade credit or in inventory? How many suppliers are not being paid because a business is waiting to be paid by their customers? This is the part of the profitability equation that can be overlooked to the peril of the organisation. This is why businesses need to focus equally on cashflow as well as the P&L.
How quickly your customers pay you is traditionally measured in days and is known as “Debtor Days” or “Accounts Receivable”. Similarly payment of suppliers is also measured in days and is known as “Days Payable Outstanding“ or “Accounts Payable.” Ideally your Debtor Days will be equal to or less than your Days Payable Outstanding. It is in your business’s interest to ensure you are easy for your customers and suppliers to deal with. Make sure there is no confusion about what products and services have been provided or purchased, and what and when payment is expected. This will minimise the opportunity for delaying tactics and the unintended extension of payment terms.
Finally, for those selling products, measurement of stock levels is traditionally done by determining how often stock need to be replenish each year? This is known as stock turns. A high number means that stock is continually being converted into sales and therefore cash is being deposited into the bank. By the way, there are benefits in having high inventory levels. Buying in bulk can reduce “the per” item cost and can protect against price fluctuations. Having stock on hand prevents the cost of possible interruptions in the production process. It also ensures that you always have product on hand for your customer to order, preventing them from the need to “go shopping” for alternative suppliers. All these factors help businesses to strengthen long-term relationships with their customers. As a business owner you must be aware of the pros & cons of your current stock levels and how it affects your cashflow.
I was reminded while meeting with a financial expert last week, that to remain viable, organisations must attempt to meet their short-term liabilities (money owed by the business eg suppliers) with their short-term assets (cash in the bank, money owed to the business by customers and/or sale of inventory). Similarly the long-term liabilities (eg bank loans) should be covered by the long-term assets (eg owned Plant & Equipment). If there are not enough assets to cover the liabilities, then organisations become insolvent.
As my financial friend further reminded me there are two rules in business:
- Always earn more than you spend
- Do not forget rule 1
Please contact Robert Carter on This email address is being protected from spambots. You need JavaScript enabled to view it. if you would like to discuss any of this or would like to undertake a review of any part of your business using my 16 Point Checklist.
