Profits, Growth and Cash Flow – Which is Most Important to Small Business Success?

Business growth and profitability. Most entrepreneurs would consider these to be the Holy Grail of business ownership. So it’s not too surprising that many participants in the financial workshops I lead are surprised when I tell them that instant profits and rapid business growth aren’t always a cause for celebration.

“How can this be?” you might be wondering. The best way to explain it is to tell the story of the Wonder Widget Company. Haven’t heard of them? Well, this is a fictitious company I made up to help me explain business financial concepts in an easy-to-understand way.

A Hot New Launch

Wonder Widget Co. launched last year with $100,000 in cash and the hottest new product in its market, the amazing Wonder Widget. It was so hot that the owners had sales and profits the very first month of operations. So they quickly leased and outfitted a factory, production equipment and furnishings (all with minimal initial cash outlay), bought materials, hired workers, and manufactured and shipped widgets. Then they mailed invoices totaling $50,000 to customers in the first month. Amazing!

They paid their bills as they came due and collected from customers in the normal course of doing business. Meanwhile, sales continued to grow, increasing by $50,000 every month with no decline in margins and no serious competition, and profits climbed without a pause.

But a strange thing happened on the way to the bank: The owners were shocked to find that they didn’t have enough cash to pay their bills. Soon, they couldn’t buy any more raw materials to manufacture Wonder Widgets or make their payroll. Instantly profitable Wonder Widget Co. was insolvent six months after they opened the doors.

On the surface, it’s hard to see how something like this could happen to a profitable and growing business. But when you dig a little deeper, it becomes clear that there’s a whole lot more to running a successful business than just profits and growth-namely, cash flow.

The Cash Flow Cycle

Understanding what happened to Wonder Widget Co. starts by understanding what’s known as the cash flow cycle. This is the time lag that exists between when cash is paid out by the business for things like equipment, raw materials and salaries and when accounts receivable are collected. In manufacturing, the cycle usually consists of converting cash into raw materials, finished goods, receivables, and then back to cash again.

At the beginning of the cash flow cycle, nearly every business starts out with-you guessed it-cash. But from that point on, the central purpose of the business is to convert that cash into other kinds of assets or to leverage or extend it with liabilities, and ultimately to turn it back into cash again-but this time, more cash than the business started with. This process continues indefinitely and simultaneously throughout the life of a business.

When the company started up, its first activities revolved around setup-renting facilities, getting phones and utilities installed, etc. At the same time, it was purchasing assets so it could start operations. These included office equipment, computers and the like. Of course, the company also needed employees to answer phones, run the office, and produce and sell Wonder Widgets. The owners financed some of these costs, but obtained credit via bank loans to cover most of them.

With all this in place, the company was ready to begin production, or the manufacture of Wonder Widgets. Unfortunately, the process consumed even more cash: wages, taxes, sales and marketing, more raw materials, and so on. In fact, this is the period of greatest cash consumption for most companies, as they are in full production mode but no cash is coming in yet.

Finally, Wonder Widgets was ready to sell its products and begin the process of recovering all the cash it has been spending (or investing) in the business. However, while sales were brisk, they were made on “net-30” day terms, which means the company won’t actually receive cash from these sales for another 30 to 45 days, at least.

To add to the challenge, growing sales means the company had to buy more raw materials than they did the first time around. Since they were selling more each month than the prior month, they needed to not only replace inventories consumed but also buy additional goods to satisfy their growing sales demand. Purchases can actually exceed sales in such a fast-growing environment.

Collections are the final step in the process. While this might seem like a minor activity in comparison to production or sales, it’s actually the most critical task in making every other step pay off. Unfortunately, it’s the step that many businesses, including Wonder Widgets, neglect-and that leads to their ultimate demise.

Don’t Give It Away

Are you starting to see how Wonder Widgets failed despite having strong profits and sales right out of the gate? Nolan Bushnell, the founder of Atari and Chuck E. Cheese Restaurants, put it this way: A sale is a gift to the customer until the money is in the bank. This final step is the one that turns the entire effort-setup, purchasing assets, hiring employees, obtaining credit, and producing and selling products-back into cash again.

At this point, the answers to some important questions will begin to surface, like: Did the company ultimately make a profit on its business activities? Did it plan adequately for the working capital it would need to finance the cash flow cycle in it’s entirety? As the Wonder Widget story makes clear, answering “yes” to just the first question isn’t enough to ensure business survival. There are three key takeaways from this story:

1. Fast growth is a double-edge sword. Fast-growing companies need more working capital than those growing more slowly or not at all. When incoming cash flow is delayed while fixed costs continue and paydays come every week, there’s a limit to how long a company can operate comfortably, even if it’s profitable.

2. Cash flow needs must be forecasted months in advance. This is especially critical during the early months of a startup. And cash flow results must be tracked separately from profits.

3. Business goes with the flow. The health of a business depends on the health of its cash flow. As Wonder Widget Co. makes clear, more businesses fail due to a lack of cash flow than a lack of profits.

Benefits of Blogs For Business Marketing

After the advent of the World Wide Web the next big fad was blogging. Suddenly everybody from home-makers, young mothers, businessmen, and grandparents were blogging. Personal blogs sprung up dime a dozen all over the internet, leading to a blogging network of similar blogs and bloggers. The word ‘blog’ sprung from the term ‘web log’ coined by Jorn Barger in 1997. The blogging boom began with the appearance of easy-to-use blogging software developed in 1999.

What exactly is a blog?

A blog is an online journal that can be updated at your convenience. You can have a personal blog, like keeping a diary open for public viewing or a business blog maintained in order to have a platform to discuss business-related topics and share your expertise online with potential customers, interested clients, or your employees.

7 Marketing benefits of having a business blog

Having a business blog can have several advantages for a small business on a tight marketing budget. If you do not have web designing know-how, a blog is a great alternative that offers free setup and easy maintenance.

You can offer helpful hints and promote your own products, upload instructional or demonstrational videos on to your blog. You can build a subscriber base using your blog, and generate leads by notifying your followers when you have new content up. Google’s Blogger allows for Google AdWords to post ads on related products or services in your blogging space, giving you the option of passive earnings through affiliate marketing. Listed here are 7 important benefits blogging offers to business marketing:

1. Low-cost internet marketing tool: Opening a blogging account on Blogger or WordPress is free and you have the required software to be all set in a few hours. However, it is important to host your own blog even if you use free blogging software. Registering your own domain name and having your blog on your own server space gives you better visibility in search engine rankings.

2. Drive web traffic to your business website: When you have a blog and a regular following it is like having another website, but with reduced functionality. Your blog will rely on SEO articles, images, or videos. Your followers can be redirected to your business website if you have one, with the goal of converting interest or leads into sales.

Make an SEO keyword list for your niche market and base your articles and videos on these keywords. This will drive both natural and paid search to your blog. Include your blog URL in your social networking site profiles encouraging friends or fans to follow your business blog. This will drive traffic if you have a reputation for great information or expertise in chosen your niche.

3. Build your product or brand image: You can build your brand imageusing your blog. People reading your blog maybe interested to know what you do – add your business widget or button to your blog. Write a product description or post an infomercial.

4. Maintain a customer dialog: Blogs are interactive, which means that your readers can interact with you through posted comments and questions on the blog (which can be moderated). This is your chance to weigh customer opinion, suggestions, and comments.

5. Gain new customers: Some followers may recommend your blog to others bringing you new business prospects.

6. Network with other similar businesses: All businesses run on internal and external networks. Keeping up with similar blogs and their articles can give you an opportunity to comment on their articles while adding value to them presenting your knowledge on the subject. A reader interested in their blog may click-through to yours to read more! These kinds of click-throughs are free and generate more traffic to your blog.

7. Great public relations outlet: In case, your business runs into some bad press your blog can be your chance to demonstrate a clean slate. You can make your stand clear or challenge a public opinion. As regular readers are aware of who you are and know you from regular online interaction, you have a better chance to garner support through viral means.

Blogs are great additions to your Social media marketing (SMM) strategy. For those who do not have the money to pay for website design and site building, blogs double up as a website cum interactive online tool. The only downside is that they do not provide the functionality of web pages, have limits for e-commerce solutions, and can be time-consuming with regular posts; but blogs rank high as a low-cost marketing option.

Why Use EBITDA Instead of Net Income When Valuing a Business?

When calculating the value of a business most valuations rely on a multiple of EBITDA instead of a multiple of profits. Occasionally, a buyer will object, saying that his return will be after taxes, interest, and depreciation so the profit figure should be used instead of EBITDA. The reason that approach does not work is that the cost of the items that are backed out in EBITDA depend on the sellers circumstances and may be quite different for the buyer.

Let’s look at an example. Assume that we have two businesses (A Widget Inc. and B Widget Maker). Each of the two companies produces the same number of identical widgets, which they sell for the same price, using a machine that cost $2,000,000 and each financed the machine using a bank loan. Because of their credit histories the first company pays 5% on the loan while the second company pays 15%. A Widget Inc. is a sole proprietorship and so shows no corporate taxes on its income statement but B Widget Maker is a C Corp it is paying $100,000 in corporate taxes. Our two widget companies occupy identical buildings, side by side. A Widget Inc. acquired their building a decade ago and this year will be able to take only $100,000 in depreciation. B Widget Maker acquired their building only one year ago and because of the high purchase price will be able to take $400,000 in depreciation on this year’s income statement.

Let’s look at the income statements for these two companies:

……………………………. A Widget Inc……….B Widget Maker

Sales…………………………5,000,000……………..5,000,000
Cost of Goods Sold……..2,000,000……………..2,000,000
Other Expenses*…………1,000,000……………..1,000,000
EBITDA……………………..2,000,000……………..2,000,000
Interest……………………..100,000…………………..300,000
Taxes……………………………….0……………………..100,000
Depreciation…………………100,000…………………400,000
Profits………………………..1,800,000……………..1,200,000

*All other expenses except Interest, Taxes, and Depreciation.

In our simplified universe, based on the excess earnings method of valuation, A would be worth 50% more than B (since 180,00 if 150% of 120,000). But let’s look at what happens to their earnings after you acquire them.

You are going to refinance the machines. Your credit history is better than B’s but you are unwilling to pledge your house as collateral (which A did to get his low rate) so in both cases you could get a rate of 7% (making the interest only payment on the loan $140,000). In both cases you will mark up the value of the building to fair market value, on which you’ll be able to take $450,000 in depreciation. Your company is organized as a C Corporation, and you project taxes on the additional profits at $80,000. Post acquisition, in either case your profits are identical.

So, you ask why not pay on a multiple of what you project your EBITDA would have been? You may internally calculate the rate of return that you’d like to see after non-cash expenses but talking to a seller about your taxes, methods of depreciation, and financing costs is never a good idea. and remember that if you are calculating a multiple based on profits and you want to close deals you’ll need to make the multiple higher since other buyers will be basing theirs on EBITDA.

Finally, I want to add a note about depreciation since with this non-cash expense the problem becomes a little more complex. There is a great deal of latitude in choosing what depreciation method a company uses and often the useful life that is assumed for depreciation is not an accurate reflection of the real world. You certainly do not want to value a company more highly simply because it chose a less aggressive depreciation schedule. In some circumstances, however, depreciation may represent a reasonable approximation of a real expense. I have, for example, seen buyers in the non-emergency medical transportation business who used a seven year depreciation schedule as a proxy for the cost of replacing a fleet of vehicles, which they decided was necessary roughly every seven years. In those cases I have seen buyer and seller agree to talk in terms of EBIT.