What’s the financial story of your business?

Every business has a financial story – a narrative woven through the numbers that speaks to its past, present and future.

Understanding this story is a bit like learning a new language. It’s certainly the most important language you can learn as a business owner! Once you understand your story, you’re better placed to make strategic decisions and ensure the financial health of your business.

Here’s how I read financial stories and how you can leverage yours to drive your business forward.

– Darrin

When I first review a company’s financials, my attention focuses on three key indicators:

1. Gross profit
2. Cash flow
3. Overheads

These metrics are not just numbers – they narrate the financial health and operational story of your business.

In a financial review, I typically use an 80/15/5 approach. I’ll allocate 80% of the time to analysing gross profit, 15% to cash flow, and 5% to overheads.

Today I’ll dive into the big guy, gross profit. I’ll explain why it’s so important and share some tips for improving gross profit in your business. I’ll follow up with an explanation of cash flow and overheads next time.

Gross profit is essential for evaluating the profitability of your core business activities. We work it out by deducting your cost of goods sold (COGS) from your total revenue. This gives us your gross profit in dollars, which we then use to calculate your gross profit margin. Your gross profit margin is the ratio of gross profit to total revenue, expressed as a percentage.

When analysing a business’ gross profit, I start by looking into several things:

Direct profitability of key products or services

Which are making money? Which are not? I also look at demand trends here; is the market you’re focusing on big enough to achieve your goals?

Efficiency and cost-effectiveness of your production processes

• Services businesses: What is the cost to deliver your revenue? The key items I explore here are your billable percentage (billable vs. non-billable time) and write-offs (work you’ve completed but can’t bill for, e.g. fix-ups or going over-budget). Once you understand what drives these two metrics, you can unlock a load of business improvement measures. For example, if your write-offs are high, this can be due to incorrect pricing or scope creep. There are many drivers here to investigate and improve.
• Product-based businesses: What is the exact cost to make and deliver your product? As with services businesses, once you dig into the numbers you’ll start to see what is driving your costs. Start with high-cost components and go from there. There are always tweaks and improvements that can be made.

Adequacy of pricing strategies relative to incurred costs

Is your pricing helping or harming you? For example, are the costs associated with promoting or discounting your product outweighed by enough of a volume increase? Are you able to increase the customer value by upselling a complimentary product or service after the discounted item purchase?

Next step: improvements

Once you have a solid understanding of the drivers behind your current gross profit position, it’s time to make changes. Here are some examples of how you might improve your gross profit.

• Review your pricing strategy
  • Increasing prices is the easiest lever to pull to improve gross profit, as the increase flows straight to your bottom line. The key is to do so without alienating your customers or becoming uncompetitive. Consider the simple adage: if you’re winning every job, your prices might be too low; if you’re losing too many, they might be too high (or you’re wasting time on tire-kickers).
  • Also consider how far out you’re pricing. If the job won’t commence for six months or more, be sure to allow for things like cost increases and foreign exchange fluctuations.

• Reduce production costs
  • To lower production costs, you need to understand the main contributing factors then track and manage them. For example:
    • Can you lower your COGS by negotiating sharper pricing with your suppliers? Or can you improve efficiency through employing better technology?
    • Services businesses – if you’re not on-charging all of your team’s time, why not? Is there scope creep? Do you need to further develop your scoping process?
    • Services businesses – does your team have a large percentage of unbillable time? How can you reduce this?
    • Can you improve efficiency by analysing which combination of team members work better together, and run with these teams permanently?

• Optimise your product mix
  • • Focusing your marketing and sales efforts on products or services with higher margins will boost your overall gross profit.
    • Analyze your product mix to identify potentially loss-making items buoyed by profitable ones.
    • Consider factors beyond financial returns when making decisions; understand the true impact of each product or service. For instance, while entry-level design work may have low gross profit, it could lead to more profitable implementation stages. Similarly, a smaller-sized product might serve as an entry point for upselling.
    • Be sure to test your assumptions thoroughly, and verify your thinking with data.

• Understand the impact discounting has on your business short term and long term
  • While discounting can be tempting, especially in a tight market, it’s essential to evaluate its necessity and long-term consequences. Look before you leap!

It’s amazing what the three metrics of gross profit, cash flow and overheads can tell me about a business.

If you’d like us to take a look at one or all of these, let’s schedule a time to chat.

Darrin Brown, Virtual CFO
0800 422 526