One of my favorite small business finance books* is Greg Crabtree’s “Simple Numbers, Straight Talk, Big Profits.” He takes what is typically viewed as a dry, painful topic and makes it compelling — and, more importantly, he cuts through a lot of noise and shares some excellent, practical advice on how to create a profitable business.
(*Note: To be fair, my list of favorite small business finance books is pretty short — but this is still a fantastic book by any measure.)
As an example, one of the key themes of the book is that you need to start thinking about your business differently — specifically, you need to realize that your business is like a cow.
There are lots of ways to think about your business, and it’s easy to get distracted by different ideas of growth. But growth doesn’t necessarily reflect that your business is healthy. There are plenty of businesses that have had great top-line growth — right up until they ended up closing the doors and going bankrupt!
Alternatively, if you think of your business like a cow, the goal is to keep that cow healthy so that it can provide for you now and in the future. A healthy cow not only provides milk every day, but it’s also worth something down the road should you consider selling it. An unhealthy cow doesn’t provide milk, and if it gets bad enough, it will die — with no value to the owner (plus, that’s just a bummer).
“You can keep the cow healthy and milk it every day, or you can have one big barbeque dinner.”
— Greg Crabtree
4 Keys to a Healthy Business
What does it take to keep that cow/business healthy? Here are 4 things to consider.
1. Legitimate Owner Compensation
Figuring out what a business owner should be paid can be a tricky thing. Early on, owners will often not pay themselves at all, instead opting to invest in the growth of the business over their own salary. However, beyond that initial start-up phase, it’s critical that an owner gets paid a reasonable market-based wage for the position he or she holds.
“You get paid a salary for what you do and get a return on what you own.”
— Greg Crabtree
This is important for a lot of reasons, but for starters, this puts your business on common footing with other businesses so that you can actually compare how you’re doing. If an owner isn’t paying himself, then it’s not possible to really calculate the overall profitability — and profitability is how you can tell if you’re running a healthy business (see point No. 2).
This also becomes important if you ever want to sell your business — because a new owner (and the bank) will need to understand your real profit numbers.
2. 10 Percent Profit is the New Break-Even
The health of your business is measured by profitability, not revenue – and 10 percent pre-tax profit is the recommended minimum target line.
It’s a good idea to keep things simple here: Profit is literally calculated as your revenue (sales) minus all your costs before you pay taxes. Think about it as the amount of milk your cow can generate every year.
Breaking Even isn’t Good Enough. There’s a natural tendency to focus on break-even as the horizon. The problem with break-even is that you’re not generating any return on the investment for the ownership, which isn’t sustainable. (Why would you own an investment long term that never paid you anything?) And there’s no room for error if you have a bad month or a bad quarter – you’re losing money. Here’s the breakdown:
- 5 percent or less of pretax profit means your business is on life support.
- 10 percent of pretax profit means you have a good business.
- 15 percent or more pretax profit means you have a great business.
Of course, this is a general view (some industries don’t have this much margin; others may have more), and it also depends on how large your business is, but, in general, once you’re over $1M in revenue then this idea will apply (again, if you want a healthy cow).
3. Labor Productivity is the Key to Scalable Growth
It’s critical that you have a way to measure company performance. Put another way, how effective are you at generating revenue with the resources you have?
The most straightforward way to measure this is your gross profit per labor hour: How much money does the business generate for the money you pay out in salary? (Likely your biggest expense.)
One way to think about this is to put your business on a salary cap (like the NFL uses for their teams). This article (Does your business have a salary cap) goes into depth to explain the idea, but the bottom line is that healthy growth comes from consistently finding ways to get more with less. Easier said than done, but very important.
4. Keep a Critical Eye on Your Cash Flow
The final point to consider for keeping a financially healthy business is making sure you have a handle on your cash flow — which, for many businesses, can be very different than your profit and loss.
Specifically, it’s critical to allocate cash in this order: first for paying taxes, repaying debt, building up a working capital reserve (two months of expenses) and then distributing profits.
That seems pretty obvious, but if you don’t follow this idea, you will get yourself in trouble at some point.
It takes a lot of work and foresight to keep a business healthy — especially if you’re also actively growing that business. But the payoff is not only a steady flow of profits (milk), but also a healthy business that’s intrinsically worth a lot more should you choose to sell … and the added bonus is that a healthy business is also a lot easier to run.
What do you think? Do you look at your business like a cow? Or will you look at it like a cow now? We’d love to hear your thoughts.
Shawn Kinkade, Kansas City Business Coach