My name is Bob Windmill and I am the Managing Director of Windmill Insight Solutions Ltd.My passion is helping people and organisations become better at what they want to do. My blog is a way of sharing with you the sorts of projects I am involved in.
I also write about how you can help yourself or your organisation become better at what you do.
Of course, what “better” means is an entirely different discussion, but I will write about that on another day.
In today’s topic I will talk about how a business works with money, the key money related terms needed in business and the pitfalls that await business owners and employees that don’t have a sensible grasp of basic business finance.
I picked this topic because money is the lifeblood of every business, even not-for-profits, and it is vital that both business owners and employees understand how it woks and how to avoid the pitfalls that await the financially naive.
Business money basics
Do you understand the difference between income and profit? How about the difference between cash flow and profit?
These concepts are the lifeblood of any business and it is important that every business owner understands them well.
My feeling is that these are also good things for an employee in an organisation to understand.
After all, as an employee you want to work for a successful organisation. Part ensuring the success of the organisation that you work for is making sure that you understand how it makes a profit.
The aim of this post is to help you understand how a business generates income and profit and pays its bills. It is a nice gentle introduction to the subject which will hopefully show how simple it can be.
As an example the first sentence is a learning point: income is not the same of profit. Similarly getting excited about your businesses turnover is all well and good, but what does it tell you about the profit you are making?
The key point is that every business operates in the same basic way:
- start with some money
- use the money to buy materials and people skills with which to create something
- sell that something
- get paid
- settle your bills and pay your taxes
- take some of the money out to live on
- put the rest back into the business at point and do it all again. And again. And again…….
This process is sometimes referred to as the money cycle. While simple is does contain some traps for the unwary so it is worth spending some time learning about it.
The key point in business is that you are normally spending your own money in order to get paid at some future date. If nothing else hang on to that thoughts.
So, the first take-way thought is “You need cash in hand to pay your bills“. Very simple but so often forgotten.
The money cycle and its traps
Let’s have a look at the elements of the money cycle in more detail before we look at the traps.
- Start with some money.
This is often referred to as your start-up capital. It can be your on money or it can be borrowed. The important point is that your start-up capital has to be enough to fund your early costs until you start to generate income. Typically your costs will include rent for premises, stock, materials, advertising, tools and machinery, staff wages, and your own living costs.
- Use the money to buy materials and people skills to create something.
The “something” can be a physical item like a dress or handbag. It can also be a service like a beauty treatment or the retailing of someone else’s products. The assumption here is that you have done your market research and have created something that your potential clients want to buy, and that they want to buy it from you rather than one of your competitors.
- Sell that something
Here we are just thinking about the money cycle, not about how you actually make the sales. How you identify and sell to profitable clients is a subject for another day.
- Get paid
Yes, getting paid is different from making the sale and it is really important that you understand the difference.Why? Because if you don’t you will very soon understand the phrase “cash-flow problem“, something that you would do well to avoid.
- Settle your business bills
You remember all those expenses I referred to at the start of this article, things like rent, stock, materials and people costs. In a perfect world this is where you you pay these bills using money from current sales. However the reality is that you will have to use your working capital to do this.
- Take some money out to live on (and enjoy)
This is the point of most businesses – they provide you with an income that enables you to do the things that you want to do. As a starting point the income should enable you to pay your personal bills but for me it should also be enough also allow you to enjoy things like holidays and generally having fun.
- Put the rest back into the business and do it all again
This is a critical point. Successful businesses are constantly re-investing. The re-investment can be in material and stocks, training and development or market research. The important point is that you invest enough to keep your business growing and developing.
The key point here is that most of the money in the business is not yours. Some belongs to the tax man, some to your suppliers and some you need to grow your business. Only what is left over belongs to you.
The take-away thought here is:”The business owns the money and its needs come first“
At this point its worth reminding ourselves of the words used to describe how money works in business
- Income is what you get paid for the products and services that you have sold. My preference is to record income as both Gross Income and Nett Income. The former is what arrives in my bank account while the latter is what is left after sales taxes such as the UK Value Added tax. As an example if a client give me £100 I must immediately put £20 to one side to pay to the tax authorities. This give me a nett income of £80 – quite a big difference
- Expenses are the costs that you incur in running your business and creating the products and services that you intend to sell.
Technically expenses break down into Fixed Costs like rent, wages, interest payments and insurance and Variable Costs like raw materials.
Fixed Costs are incurred regardless of how much business you are doing and are sometimes referred to as “Overheads”.They can be a real problem when business is slow and you don’t have much money coming in. Variable Costs are a bit easier to deal with because you are spending money in the expectation of making more money at some point in the future. However, and this is important, you will normally have to spend your own money up front and wait to get paid.
- Turnover is the gross income that you generate in a given period. It is broadly a sign of how well your business is doing. A high turnover is better than a low turnover but only if you are making the proper profit margin. Do remember: There is a wonderful saying: “Turnover is vanity, profit is sanity“. Keep it in mind. Working capital is the amount of money you need to keep in hand to pay your bills and develop your business. A common mistake is to forget that this money belongs to the business, not the business owner.
- Profit is the difference between your Nett Income and your Expenses. simple, isn’t it. As with Expenses profit comes in two forms: Gross Profit and Nett Profit. The difference is that Gross Profits are subject to taxation and Nett Profits are what you have left after you have paid those taxes. In the UK the difference can be as much as 40%. Ouch.
- Accounts are just a record of the money that you earn and spend. My approach is that accounts should be as simple as possible.
As an example I run my business on a spreadsheet with two tabs, one for what I earn and one for what I spend.This enables me to see at a glance my current financial position.
At the end of each financial year I send the spreadsheet and paperwork to my accountant who tells me what tax is due. simple, isn’t it. If you don’t have access to a computer it is entirely possible to do the same thing with cheap note book, it just means that you have to do the calculations manually.
The take-away point here is “Understand the difference between Nett and Gross income and Nett and Gross profit“
The cash flow trap
Let’s start with a question. How can a very profitable business with full order books fail? Any ideas?
Surely of a business that is making lots of money and has customers waiting to buy their products and services can’t possibly fail, can it?
The short answer is “Yes, it can”. I touched on the reason in the money cycle discussion.
In business you make agreements with people to pay them money in return for goods and services.
The key point is that the nature of the goods and services and the size and timings of payments are normally specified in a contract.
The rule in business is that people will want paying the agreed amount at the agreed time. More importantly you have a contract with each of them in which you agree to pay at the agreed times.
If you have not yet been paid by your customers, that is your hard luck.
If you can’t pay because you don’t have sufficient cash in hand you have a “cash flow problem” – situation where money is required to flow from you to your customers before you have enough money flowing in from your customers to cover the bill.
Yes, cash flow problems really are a simple as that – at a certain moment in time you do not have enough money to pay a bill that is due even though you know that you will have the necessary money coming in soon.
If this is a one-off event the situation is not the end of the world. It is often possible to negotiate with the people you own money to (your creditors) and come to a new arrangements.
However if this becomes a regular occurrence your business reputation will rapidly decline, and credit will become harder to get.
Your bank will start getting nervous and your suppliers may require you to pay in advance for your supplies. This is a bad situation to be in.
The bottom line is that the people you owe money to are legally entitled to demand payment at the agreed time.
In the UK the law is quite clear: if you cannot pay your bills at the time they are due you are trading insolvently and it is legal offence for the business owner to knowingly trade insolvently.
Yes, it’s as black and white as that – if you know can’t pay you bills you must stop trading or find a way to pay the bills. End of story.
The take-away point here is “Understand your your obligations and that hoping for the best is not substitute for proper financial planning“.
Avoiding the cash flow trap
Avoiding the cash flow trap is easy in principle: you just need to make sure that you keep enough cash in hand to pay your own bills while you are waiting for your customers to pay you.
OK, if its so simple why doesn’t everybody do it?
One of the commonest reasons is that the business owner under-estimates the amount of Working Capital that they will need.
As I noted earlier Working Capital is the money that a business needs to keep in hand to pay its bills and develop its customer base.
Many new businesses use bank loans for their Working Capital. The temptation in this situation is to ask for a smaller amount of money in order to keep the repayments down. Don’t do this.
Yes, asking for relatively large sums of money is difficult. However it is but not nearly as difficult as going back to bank after a few months to ask for more money because you got your forecasts wrong!
Look at it from a bank manager’s point of view: you were lent money on the basis of a business plan which turned out to be wrong. What is there to say that your new business plan will be any better?
Bank manager’s get nervous in these situations and a nervous bank manager is less likely to give you the help you need.
Another common reason for a cash flow problem is that a business owner doesn’t understand the difference between Gross and Nett income and Gross and Nett Profit. This means that they are not putting money aside to pay their tax bill.
As an example, how often have we seen a newspaper headline that the tax authorities are taking a celebrity to court over an unpaid tax bill. Often these celebrities are very well paid and live lavish lifestyles but appear unable to pay their tax bill.
This is a classic example of someone with a special skill or talent not understanding how business money works. Don’t be like that with you business.
The take away point here is “If raising business capital is hard, going back for more because you got it wrong is ten times time harder“.
Everyone at work needs to understand how the money cycle works and the traps it contains. If you are running your own business that knowledge helps you avoid unnecessary cash flow problems and demonstrates to those providing funding that you know how to manage such issues.
Similarly I believe that a good employee should understand how their bosses business works and why the boss spends a lot of time worrying about things like overheads and cash flow.
What ever you situation time invested in understanding how business money works is a great investment.
I hope that you have enjoyed reading this post. If you have thoughts on what I have written so far please leave a comment. Also if you have an idea for a topic for this series let me know and I’ll be delighted to find a space for it.