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By Cyndi Thomason
September 14, 2020
Profit. We all know what it is, and we want it. Yet I find so many are confused about it.
Here are typical questions I get as a Profit Advisor for eCommerce Sellers:
In this article, I will try to answer each of the questions as I explain why profit is important, what levers impact your profitability, and how you can get started improving your profitability immediately.
One of the best explanations I’ve seen for how money works in a business is outlined in The Ultimate Blueprint for an Insanely Successful Business by Keith J. Cunningham.
His equation says the purpose of a business is to acquire assets that are effective at generating revenue, then efficiently convert revenue to profits and to productively use the profits to create operating cash flow.
If I were to draw this out for my eCommerce clients, it would look something like this:
We use Cash to buy Inventory; these are our assets. We want to ensure these assets are effective at generating Sales, which is our Revenue.
In other words, our products should sell through quickly at a good profit margin. These sales need to be efficiently converted to profit.
Efficiency here is again looking at your profit margin on your products—looking at your costs of sale, including shipping, packaging, duties and tariffs, advertising etc.
These Profits are to be used productively to generate Cash.
Productive in this case means using the profits to cover operating expenses that are needed, not just a tax deduction strategy. And as you can see, the cash created is the input for us to repeat the cycle.
So, from this diagram we can see that Profit and Cash are not the same thing.
In fact, Cunningham says that profits are just a theory based on accounting rules. The ultimate measure is actually cash.
The reason profits don’t tell the entire story is because there are uses for cash in our business that do not show up on our Profit and Loss statement where the measure of profit resides.
Some examples include owner’s draw, purchase of inventory and repayment of liabilities. These are legitimate uses of cash, but they are outside of the profit and loss equation.
Let’s start with understanding why the Profit measure is important, what we can learn from it and how it helps us get to increased cash flow.
There are several reasons we want to understand the profit measure.
First, it is important because in the equation above, it shows us how efficient we are with converting sales into profit.
We also want to ensure that we are investing our assets wisely. Many of us start businesses to accommodate our lifestyle choices.
As a result, we must ensure that we generate enough profit to fund our lifestyle.
Have you calculated the monthly amount you need from your business to cover your basic living expenses?
This is an important first step when you’re starting your business because you’re stepping out on a limb and you need to determine how long your savings will support you while the business gets going.
While you may initially be investing much of what you make in the business, know that if you don’t begin to support yourself and your family from that business, you will likely begin to resent it.
When you build your financial plan for your business, be sure to cover your personal expenses as early as possible with Owner Pay.
While this may not be at the level you ultimately want from the business, it does recognize the effort you’re making and rewards you accordingly.
Another reason we want to be profitable is to have the needed cash to grow the business. In order to increase your inventory levels, add new products, add staff to reduce your load so you can focus on the primary roles you need to play, you need cash.
How do you know how much profit you need?
We recommend that our clients achieve a minimum gross margin of 30% to cover all the other operating expenses associated with maintaining and growing a business.
The equation to calculate gross margin looks like this:
We recommend modified cash or accrual methods of accounting to ensure that you are matching your Revenues or Sales with the Cost of the Goods Sold, including shipping, packaging, selling fees for your platform, etc.
If you are not generating 30% gross margin as calculated above, you will find it hard to generate the excess cash to grow your business.
Take note if you are significantly below this level because that indicates you are relying on debt to keep your business operating.
While debt has a place in the business, it is typically not a good practice to use debt to prop up a failing business.
Take the steps needed to ensure each product in your portfolio is generating an adequate profit.
Be ruthless; a gross margin that is too low will kill your business.
The final reason we want a profitable business it to ensure the business is attractive to potential buyers when we’re ready to exit the business. As I work with brokers, I am always encouraged to see how potential buyers look at businesses.
Many of the costs we add into the business as a tax minimization strategy are added back and it makes the business look more appealing to buyers.
However, if there are issues at the gross margin level, this makes the business less attractive.
The first two levers we evaluate are found on your Profit and Loss Statement.
Are your products and listings attracting prospects? Are you converting them? Are you adequately serving your clients to minimize product returns?
Pay attention to frequency of purchases, repeat purchase, pricing, size of transactions, and opportunities to cross-sell and upsell.
These are all factors that impact your revenue. As an accountant, it’s not my area of expertise, but I do know how critically important it is to get it right.
For expenses, you must monitor your COGS. Are your product costs low enough to generate good margins?
For eCommerce businesses, we must also monitor our Cost of Sales, our Advertising Costs.
Advertising can eat up your margin if you’re not careful. You must look at your overhead costs and interest costs.
Oftentimes product margins are slim and you must look for ways to eradicate high interest debt.
Be ruthless with your operating expenses. Do you really need all those software subscriptions? Or the latest online course? Or that office space?
When you spend money on operating expenses you are directly reducing the cash you can use to pay yourself or use to grow the business.
Look for innovative ways to do things, be efficient and frugal. These next three drivers can be found on your balance sheet.
The first is Receivable Days. As eCommerce sellers, we have little control over this.
The platforms typically dictate those terms.
Make sure you understand what your options are and that you have optimized the payment terms as much as possible.
Inventory Days is a driver that requires your attention.
Basically, explore every aspect of your supplier relationships to improve your inventory costs not only for the product but for holding and carrying the inventory.
Working with our clients, we look at existing products, starting with the top 20% of sales (dollars and orders) to ensure they are achieving an appropriate gross margin.
If not, we start looking for areas to improve, by adjusting price, renegotiating shipping or production costs, etc.
We then look at the lowest 20% of sales and see if the costs of carrying these items justifies the use of our cash. Concentrating on this lever allows you to make small changes that yield big results in your profits and your cash.
The final lever is Payable Days. What can you do to stretch the payments at no penalty?
Can you negotiate longer terms, adjust payments to weekly, not daily and make sure you avoid late charges?
There are many options available now for funding that gives you 60-90 days of no interest.
If you’re considering these, make sure you’re using this debt wisely. Debt can be helpful if it’s used as a bridge, paying for inventory knowing your settlement comes in a few days.
Debt can help if you get good terms and you have done your homework to ensure a positive return on your use of the funds.
Debt should not be used as a last-ditch effort to save the business. To save your personal credit, do not take risks with debt when you are unsure of making a return.
The levers all contribute to improving your profitability and ultimately your cash flow. Take a look at your business and determine which lever needs the most attention.
Focus on that for a month to really dial it in. Then the next month, pick the next most needed lever and work on it.
I’ve seen many of our clients make no progress because they get overwhelmed trying to do it all.
Pick one, work it, pick another, and every month your dedicated efforts will build and provide you a handsome payoff: Profits and Cash.
We also work with our clients on a cash management program called Profit First. The methods of Profit First work with your natural behaviors around money to help you manage your business more successfully.
The methodology uses separate bank accounts for items like Inventory, Profit, Taxes, Owner Pay and Operating expenses to give your money purpose and visibility.
The author’s views are entirely his or her own and may not always reflect the views of SellersFunding.