REBUILDING A BUSINESS: ECONOMIC ENGINE - Written by Dr Anton Verwey
This is the fourth contribution in this series of short conversation pieces. In the first article, we spoke about the necessity to focus on individual or personal purpose, in the second we focused on the market and customers, and in the previous article explored the notion of business purpose beyond profits.
Given the preceding three articles, it may be easy to think that making money is not important. Nothing could be further from the truth. Any and all enterprises, even NGO's, need to generate revenue in order to deliver on their purpose. Of course, we would argue that revenue, or specifically profit, should not be the most important measure of business impact, but nonetheless good financial performance is a key aspect of enterprise sustainability. So how do we think about financial performance of an enterprise?
First let us consider revenue or income. As we all know, revenue is simply a function of units sold times the unit price. But who determines price? Usually, we think that we as the business owner add up all our costs, add a margin for profit, and this determines price. The simple fact though is that the price you decide on is simply an offer to the market. If the market cannot or do not wish to pay your price, it simply won't. This becomes particularly important in the current context, and what we can expect in the aftermath of global lockdown and economic contraction. After all, we can reasonably expect people to have less disposable income, and for businesses to have less disposable income as they are also struggling to recover from the impact of restricted trade. Unless your business provides products or services to very niche markets NOT affected by economic slowdown, you simply will have to think about your expected price, as well as your costs.
Secondly, let us consider the costs in your business. These can typically be thought of as follows:
• Fixed costs, i.e. those you would have whether you have sales or not. This could include buildings, equipment, interest on loans and even employees;
• Variable costs such as input material, energy consumption and other elements that are a function of how much you produce and sell;
• Cash reserves required to manage risk and make provision for growth; and
• Provision for expected profit (retained revenue).
Although most accountants may find some of this reasoning strange, our point of departure is that the only thing that really should matter in a business is the cash it generates. After all, revenue is ambition, profit is a line on an income statement, and cash is reality. Most business that cease to exist in fact do not become bankrupt (more liabilities that assets), but die because they run out of cash. Does such a cash focus on business lead to very conservative financial management? Absolutely it does. However, it is not more conservative than financial advisors would suggest we do with our personal finances. After all, they all suggest that we should save 20% or more of income for retirement. They all suggest we should get rid of debt as quickly as possible. Why? Because they know that family security and well-being is a direct function of disposable cash. Why should we then think differently about business?
To summarize, the economic engine of your business is simply the following formula:
Retained / Disposable Cash =
(Sales Volume x Sales Price) MINUS
(Fixed Cost + Variable Cost + Cash Reserve + Profit Margin).
If the calculation leads to something equal to or less than zero, you have no business unless you can increase revenue or decrease cost (or both). This is the simple reality of any and all businesses regardless of size, industry or ownership. We have worked with NGO's, enterprises of various sizes and across a range of industries, and the consequences of lockdown have had precisely the same impact on all of them. It obviously reduced revenue, but more significantly depleted cash, and it is that lack of access to cash that finally leads to the closure of doors. Going forward and building (or rebuilding) your business will require of you to dramatically change your expectations about revenue, to really deeply rethink your cost structure, and above all adopt a very conservative approach to building a reserve of disposable cash.
In the next and final article, we will explore how to move from thinking and planning to action. Again, I commit to being available to act as a "thinking partner" to you. My contact details can be obtained from The Overberg Business & Lifestyle Magazine who will connect us. There will be no fees for such conversations, and whilst I may not be able to give you quick answers, sometimes it helps to just have someone to bounce our ideas off.