Hey guys, it’s David Barnett once again from DavidCbarnett.com.
This week I wanted to do a video about a very interesting call that I just did the other
day on clarity.FM.
I was speaking with a business owner from the UK, that was talking about he wanted to
ask me about what sort of metrics he felt that I felt he needed to track on a regular
basis in order to keep an eye on his business and the problem that he had his that he thought
things were going well.
And then it became apparent that one of his suppliers had missed invoiced him and he end
up owning a bunch of money that he didn’t know that he owed and it turned out that the
you know golden period that he thought he just gone through wasn’t in fact so golden
and he had actually done a little bit of a hole for himself and our conversation focused
around gross margin and understanding if your daily operating activities are actually performing
to the point where they need to be.
Before I get into the details though, I want to thank all of you who took the time couple
weeks ago during launch week to buy a copy of my new book ‘’How to sell my own business’’.
I did succeed in getting it up to the number one spot under entrepreneurship for Amazon.
So thank you very much and for those of you that didn’t get a chance to buy during launch
week, it’s available from Amazon right now at any Amazon store around the world as well
as from my blogsite www.DavidCBarnett.com as a PDF download.
So let’s talk about gross margin and I dug out an income statement here and have made
it anonymous but this is for a construction related company.
This is an actual financial statement from someone and we’ll see it appears that we
have net sales.
So this is the amount of sales at the company had and there’s another line here called
cost of sales and you’ll see that is blank and that is a huge red flag for me.
Down here, ignore the fact there’s income taxes and amortization, down here we have
interest expenses, advertising, fueled vehicles, leasing expenses, freight bank charges, professional
fees, salaries are down here, subcontracts, tools, utilities, so all the expenses of the
business are listed down here in the expenses.
And you’ll see here that there’s an operating income.
So this company is making profit and for a lot of business owners if they’re not familiar
with financial accounting, they’ll get a financial statement like this and they’ll
say hey I’m making money everything is ok but here’s the problem with this.
When I get asked to analyze a business like this one of the very first things I want to
do, is I want to do what’s called benchmarking I want to compare this business to other similar
businesses in the same industry and I’ve got different places that I can go and look
for that information.
One of the most important pieces of information is what is the gross margin.
So what do I mean by gross margin?
Basically if you look at the direct expenses related to serving the customer, after we
serve the customer how much of that invoice that we send out is then available to help
cover overhead of the business.
In an example like a restaurant I can tell you that for example food costs in a restaurant
is typically around 30% and different types of restaurants are going to have varied food
costs like Italian place might go down to 27-28, a full-service fancy restaurant with
really exotic offerings might be up into the forties but if I see a pizzeria with a 45%
food costs I know immediately one of two things happening; either their prices are too low,
there’s too much waste going on or employees are stealing cash out of the till.
There’re sales being made that are not being reported or the owner is, for example.
So it immediately raises a red flag there something going on, there is not enough money
being made off of every pizza that’s being delivered to the customer.
In this example here we have no idea what the gross margin is.
So this business owner, if he were going to look at monthly statements, he doesn’t know
if he’s charging its customers enough, he doesn’t know if too much labor is going
into each job, he doesn’t know if too many materials are going into each job, this is
a construction related business.
You could try to track those things on a project basis but for everyday business that might
be out there where you got goods coming and going and you’re serving people every day
you need to have a proper breakdown of your cost of goods sold.
So I created an example here of a better type of income statement which I often see with
construction related companies and you’re going to see immediately why this delivers
more valuable information.
So over here sales, and I didn’t try to break out these numbers because I really have
no idea what would go where, and then we have a cost of goods sold.
So instead of simply reporting the salaries that we pay out we want to know how much money
was spent on the guys actually doing the work; the direct labor, we want to know how much
money was spent on materials for the jobs.
So not the materials for repainting the back door of the shop but the materials that went
into the jobs that were working on.
We want to know what the work of vehicle fuel and work vehicle expenses are we want to know
how much to do money that we spend getting our guys out to the jobsite, freight equipment,
subcontract, you get the point.
I want to know how much money was spent at the customers say delivering the service to
the customer.
That way I can get a total cost of goods sold and determine of gross profit.
So for example let’s say this business had a target that they wanted to have a gross
profit of 50% so they billed a client $100 they want to make sure they’re not spending
more than $50 to deliver that service so that the other $50 is available to get and to go
and cover overhead expenses.
The business, if they have a properly setup cost of goods sold section on their income
statement is able to do a review of their performance very frequently, so every week
or every month you can stop and look at how are we performing by using the financial statements.
Ok, I can bet you dollars to donuts that this income statement comes from a business where
there is an owner who manages by running around.
He’s basically trying to watch everything happening, he’s got a bunch of information
in his head and as long as there’s a profit at the end of the day he thinks that he’s
doing well.
Well here’s the problem that can happen; is you can start to have creeping increases
in your prices and if you still quote jobs the same way what will happen if you’re
gross margin will start to shrink and if you’re only looking at your financial statement after
the account has prepared the year-end, which typically takes three sometimes four months
after year-end actually happen you could be looking at trying to address a problem you
know a year and a half the problem actually started to occur in the business and what
can happen in a year and a half of the business?
Quite a lot.
You can get you into cash flow issues you can get into all kinds of problems and without
knowing what your gross margins are you can start to miss identify your problems.
So you could say you know I have a receivables problem because you don’t have enough money
to pay your bills when in reality you have a gross margin problem.
Meaning either you’re spending too much to deliver the service or you’re not charging
enough to your client.
Down here on the bottom we have our overheads.
So these are the expenses that the business has to pay regardless of how many contracts
are done.
So we got our interest, our vehicle, overhead expenses for the overhead vehicle, so the
boss that drives around, the salesman who goes around quoting jobs, the fuel those of
a vehicle’s, finance charges, bank charges, office expenses, professional fees, property
taxes, I like to see repair and maintenance broken out between different classes of capital
goods.
So repair and maintenance on vehicle versus maybe the building, administrative salaries,
the owner’s salary, these things are not directly related to jobs that are being done;
their part of the overhead.
If we know that we’re defending are merging, if we know that we’re getting the proper
gross margin all the time throughout the year than income statement like this can help us
see where our problems are.
So if our gross margin is being maintained, you were always making the same among of profit
on every job that we do for our customers but our net income is declining than it’s
pretty easy to see that the problem is in the overheads.
So some of the overhead expenses are creeping up as long as you’re getting your gross
margin and your profitable you can then take your time addressing overhead expenses one
line at a time looking for waste, looking for new suppliers, better opportunities, you
know better staff in the over the administrative side of things, better deals on your internet
connection or whatnot but without having your overhead and your cost of goods sold broken
out, you’re not able to use your financial statements on a day-to-day basis or at least
a month by month basis to make sure that your business is functioning properly.
Anyways I hope that helps gives you a little bit of insight into some of the things that
I see when I’m helping people look at businesses to buy or sell and if you’re running a business
and you intend to sell it one day, it certainly makes sense to have a properly structured
income statement.
So that a buyer can make more sense of what is it you’re trying to sell them and to
make sure that you’re managing your business properly day to day so that you can maximize
profit and at the end of the day maximize the selling price of your business.
And at the very least make sure you stay open because you actually know what’s going on
in your business.
If you want to learn more about buying and selling small businesses managing the day-to-day
business make sure you go over to my blog www.InvestLocalBook.com.
There’s a place to sign up for my email as I sent you an email every Friday with a
video and new information to help you learn how to do these things better.
And don’t forget it’s April 2016 and I’ve got seven upcoming events live; events both
online and in person: • Moncton, NB
• Saint John, NB • Boston, MA
• Halifax, NS As well as a couple of online dates and you
can find that again on my blog site there’s a direct link to this Eventbrite page where
you can sign up and get your tickets.
Thanks and we’ll talk to you soon.