How to structure your financials to build up your profitability
Updated: 3 days ago
The other day I had a call with Hannah, the CEO of a workspace business. The business currently runs 2 operating sites and they are in process of getting the funding for the lease for the third site.
Hannah said to me “Bibi, I am monitoring our cash position very closely. I have figured out several ways to defer some of our cash outflows, but I am still unclear what process to follow to get profitable. Our accountant is willing to work with us to help us with this, but I am not quite sure what questions to ask him.”
Whether you are a workspace service provider or another type of services business please read on. You are really, really going to like this.
In this blog, I am going to talk about how to structure your financials so you can create truly profitable growth for your business.
What are the key metrics to evaluate your profitability
The role of return on your invested capital
What process should you follow to get to profitability?
Are you using the right criteria for measuring the effectiveness of your business?
For every investment you make you need to make sure you are getting a minimum of 50% return on that investment, in pre-tax profit. For example, if you decide to open up a new site, like Hannah in this case, and you invest £100,000 you need to make sure that you are going to get at least £50,000 profit as your return. Then the question you need to be asking yourself is when can I generate this number in profit, to justify my investment? And a 50% return is the minimum you’d expect. Most services businesses should produce a 100% return on investment.
The real key to evaluating profitability is Return on Capital. In other words, how much capital do you need to turn the business over? You should be aiming for a minimum of 50%+ pre-tax Return on Capital and if you are providing a service around 100% return on your invested capital. Otherwise, you are better off investing your money elsewhere.
Are there any barriers you should be aware of?
In the property industry, you’d want to make every site run profitably, so ideally, you’d need to have separate P&L accounts for each of the sites you are managing. Cash flow shouldn’t be an issue, once you get profitable because you will receive your rent (membership in this case) before you incur any costs related to your service. This is the beauty of the property business – you don’t have to wait to get paid. The only barrier to entry is the small amount of membership fee, or rent in some cases, so you will either have to get enough people to sign up to scale, or you just have to be very consistent and get passed that initial viability.
In some cases you will notice, however, that you have penetrated the location as deep as it is likely to go, so to keep increasing revenue profitably, you’d need to open up another site, as it was the case with Hannah. She said, “I know how I can get the new site profitable, but I really struggle with this first site.” You constantly need to keep an eye on the market and the opportunities for penetration and expansion.
What process should you follow to get profitable?
STEP 1: Draw up a simple table:
Cost of labour ___________
All other expenses ___________
Pre-tax profit 10% ___________
Then, fill in your numbers. Start with your revenue. You know your turnover in the last 12 months, so take that number and write it down next to Revenue, for example, £1 million. Then, you should write down your 10% pre-tax profit that you’d like to make out of this revenue, for example, £100,000. This will leave you with £900,000 to spend. Calculate what your costs were in the last 12 months, all costs except wages (excluding tax). If all of your other expenses were £400,000, this means that your salary cap is £500,000. If you pay £600,000 in wages, this indicates where your problem is.
STEP 2: Take your P&L account and split it into two: Gross margin and above is your business engine. All other costs below your gross margin are your operating expenses. Keep your labour costs separate for now. This is important because you can keep labour accountable for your gross margin.
Next, calculate your direct labour efficiency ratio, this is how much productivity in pounds you are getting back for each pound you send on direct labour. Put all your labour costs in one bucket, except the costs for your executives- the CEO, etc.
Direct Labour efficiency ratio = gross profit number/ direct labour costs
You should be getting a multiplier of around 2.5 gross profit per every pound spent on direct labour. If not then you need to do some work here. You have unused capacity for the revenue you are producing. Make sure you cap spending more money on salary, but look for efficiencies internally, so you can boost this profitability.
As far as your operating costs are concerning you can divide them into 5 main categories:
Payroll Tax and Benefit
Other Operating Expenses
Your operating expenses are likely to remain constant as a percentage of revenue unless you change how and where you do business. Keep an eye on your management labour costs, as having too many executives could eat into your profitability really quickly.
Your key number here is your marketing since you need to make sure you increase the number of sign up for membership (or rent) to increase profitability.
How much should you spend on marketing to ensure you get your return?
What we said to Hannah was that she needs to make sure that she gets 50%+ in pre-tax profit from her investment in marketing. Marketing costs are an experiment. You spend money to win customers when instead, you can model out what is your incremental gain in profitability. Look at your marketing spent retrospectively and compare it to the incremental profitability you’ve gained as a result of that spent.
Getting profitable is about setting targets and expectations. Once you get to 10%, you should aim to get to 15% under the same scenario. You cannot spend any more, but you can spend it differently. You can change people e.g. replace them or move them around, but you cannot spend more pounds. If it’s marketing, it is the same thing, you can change what you are spending it on as you are trying to find efficiencies because you’ve got to demonstrate that the model is viable. Once you prove this, then you start testing. You are going to intentionally choose to diminish profitability from 15% to 10 % and you can increase those discretionally spending buckets, but not to get below 10% profitability, because that’s the safe zone. 10% pre-tax profitability is your safe zone for taking incremental, accountable steps to profitable growth. Some businesses in the property industry are making 20%-30% pre-tax profit though! See if you can make this in some locations.
Hannah has really thought this through. She has found investors to secure her infrastructure capital i.e. money needed for the lease, the equipment, etc. and she is getting the landlord to agree to fund 50% of the refurbishment costs. The business model is such that it doesn’t need working capital. Her next thing is to figure out her return on marketing spent and ensure she gets to 10% profitability, as the first step. She has some ideas on how she could use price increase by repackaging the memberships, as she knows that her target audience is not price-sensitive. She also knows what they value in what they are getting in service, which is what most business owners forget. She is on a good path and with the right focus, she is going to get to profitability and start enjoying the success of her business!
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