by MHolland | Feb 22, 2024 | Accounts Payables, Accounts Receivables, Business Tips, Cash Flow
An often-overlooked ratio to track is a combination of three other ratios…
Once you calculate the other three you simply add the three to get this Turbo Ratio that I recommend all businesses with accounts receivable and inventory track.
So, what is it called?
It is called…
Your Cash Conversion Cycle
It is the measurement of how many days on average it is taking your company to convert sales into cash.
It is the combination of three separate ratios:
- Days Receivable – the number of days on average it takes to collect your accounts receivable.
- Days Inventory – the number of days on average it takes to sell your inventory.
- Days Payable – the number of days on average you take to pay your bills.
Let us go through each of these three ratios…
Your Days Receivable
Here the lower the number of days the faster you are converting your receivables in cash.
You need the following numbers to calculate your days receivable ratio:
- Opening balance of your accounts receivable, at the beginning of the month
- Closing balance of your accounts receivable at the end of the month
- Your monthly sales on credit (non-cash sales)
Add your opening accounts receivable balance to your closing accounts receivable balance and divide by 2.
Take that number and divide by your total credit sales for the month.
Multiply that number by the number of days in the month.
Accounts receivable opening balance = $100,000
Accounts receivable closing balance = $200,000
Average accounts receivable balance = ($100,000 + $200,000)/2 = $150,000
Sales for the month = $300,000
Days in the month = 30
$150,000/$300,000 x 30 = 15 days
Now let us look at the next ratio…
Your Days Inventory
Here as well, a lower number of days is better for your cash-flow.
You need the following numbers to calculate your Days Inventory ratio:
- Opening balance of your inventory, at the beginning of the month
- Closing balance of your inventory, at the end of the month
- Your Cost of Goods Sold for the month.
Add your opening inventory balance to your closing inventory balance and divide by 2.
Take that number and divide by your total Cost of Goods Sold for the month.
Multiply that number by the number of days in the month.
Inventory opening balance = $300,000
Inventory closing balance = $600,000
Average inventory balance = ($300,000 + $600,000)/2 = $450,000
Cost of Goods Sold for the month = $750,000
Days in the month = 30
$450,000/$750,000 x 30 = 18 days
On average it is taking you 18 days to turn your inventory over. In other words, to sell it.
Now let us look at the next ratio…
Your Days Payable
For this ratio, a higher number is better! Why? Because you are taking longer (i.e. more days) to pay your bills on average which means you are preserving cash for a longer period.
You need the following numbers to calculate your days payable ratio:
- Opening balance of your accounts payable, at the beginning of the month
- Closing balance of your accounts payable at the end of the month
- Your monthly Cost of Goods Sold
Add your opening accounts payable balance to your closing accounts payable balance and divide by 2.
Take that number and divide by your total Cost of Goods Sold for the month.
Multiply that number by the number of days in the month.
Accounts payable opening balance = $250,000
Accounts payable closing balance = $350,000
Average accounts payable balance = ($250,000 + $350,000)/2 = $300,000
Cost of goods sold for the month = $900,000
Days in the month = 10
$300,000/$900,000 x 30 = 10 days
Now, let us put it al together…
Your Cash Conversion Cycle
The formula for your cash conversion cycle is:
- Days receivable
- Days inventory
- Less – Days payable
Using our numbers from above we have:
Days receivable = 15 days
Days inventory = 18 days
Days payable = 10 days
Your Cash Conversion Cycle is 15 plus18 minus 10=23 days
Although this is a very crude measurement what it tells you is that on average you will convert your sales into cash in about 23 days.
In Closing
Remember the lower the number the better. Why? Intuitively you will want to convert accounts receivable and inventory to cash as quickly as possible. Less days to do so means cash is hitting your bank account more rapidly.
One other thing to keep in mind is that the Days payable number is more beneficial the higher it is! That is why it is subtracted in the Cash Conversion Cycle Formula.
The longer you take to pay your bills the more cash you have available to run your business. Here you will want to operate with integrity and not take too long to pay your suppliers. After all, they are essentially your partners in your business.
That said, it is fair if you take advantage of longer payment terms and wait as long as possible to pay.
Thank you for reading….
by MHolland | Feb 15, 2024 | Business Tips, Cash Flow
Fixed. Quite the word, isn’t it?
What images does it bring up for you?
For me, it brings up images of unchangeable, immovable, solid, stationary, set.
Fixed costs are necessary. Or at least you thought they were necessary when you incurred them.
And why did you incur them?
To attain a particular result in your business. To achieve something perceived as critically important in your business.
A New Definition of Fixed Costs
A bundle of Fixed Costs are costs of overhead needed to achieve a particular sales volume in your business.
The key is the last part. They are designed to attain a particular level of sales volume.
Unlinked to sales volume, then what exactly are they for?
Unlinked to sales volume, fixed costs have no relevance. They can only be incurred for three reasons:
- Ego gratification. For example, management loves a big, fancy office. The big, fancy office is not needed for sales volume per se.
- You incurred the cost in the past. You no longer need it; you are just trapped inside a fixed agreement like a lease.
- You have not paid any attention to your fixed costs. They just creeped forward on you unawares.
Here is a remarkably simple, personal example of “unlinked to a result” fixed costs.
Imagine you have a goal – to get fit.
You join a gym. You go for a while. Then you buy a home gym. You stop going to the gym. You continue to pay. (You are locked into a contract. You are just not thinking about it).
The fixed gym membership fee is now “unlinked” to your goal. It is an irrelevant cost.
A few of these and you have massive, fixed cost creep, and diminished or disconnected results.
Re-Thinking Your Bundle of Fixed Costs
On your Profit and Loss Statement there are three main categories.
Sales, Cost of Goods Sold, and Overhead (comprised of mostly fixed costs).
Sales less Cost of Goods equals your Gross Profit.
Your Gross Profit must cover your Fixed Costs plus your expected or desired Net Profit.
Start to think of your business, or any business, like this….
Take your Gross Profit percentage and divide it by your total Overhead (Fixed Costs) plus your desired profit and you will arrive at your required sales volume.
Now, here is the switch I want you to make in your thinking.
Think of your bundle (or group) of Fixed Costs as related to the capacity of volume your business must attain to break even and make a profit.
An Analogy
To make it clearer – think of this bundle of Fixed Costs like a machine.
You lease a machine. That is your fixed cost. The machine has a fixed, maximum capacity. It can produce so many widgets and that is it. You can determine what that is by the output per hour, as a simplified example.
Now it gets a bit tricky. Unlike a machine, your fixed costs are comprised of a group of expenses related to your sales volume capacity.
Some of those expenses will be non-contributors. They are no longer value contributors to your sales volume.
A Step-By Step Breakdown
Let us say you have $50,000 in monthly fixed costs.
Your Gross Profit Margin is 40%.
You desire a Net Profit of $20,000 per month.
Take the $50,000 and add the Planned Net Profit. You get $70,000 ($50,000 plus $20,000).
Divide that by the Gross Profit Margin of 40% and you have a required Sales Volume of $175,000 ($70,000/40% = $175,000).
Here is a simple re-work:
Sales $175,000
Cost of Goods Sold (60%) (105,000)
Gross Margin – 40% 70,000
Fixed Costs 50,000
Net Profit $20,000
You sell one product at $10 each. Your break-even sales volume is 17,500 units ($175,000/$10 per unit) = 17,500 units).
Okay, so now you can think of your Fixed Costs as having to produce (like a machine) 17,500 units.
Three Crucial Questions
Now in examining your Fixed Costs bundle with this latest information related to capacity, you must ask yourself these questions:
- Is my business capable of producing 17,500 units, with this bundle of costs?
- Is my business not capable of producing 17,500 units with this particular bundle of costs?
- Is my business capable of producing 17,500 units, yet could do so much more efficiently?
Now, go through each expense and ask these two questions:
- Is this cost necessary to produce my required volume of 17,500 units? If not, kill it if possible.
- Is this cost necessary, yet too high? If yes, try to renegotiate contracts or find new suppliers with less cost for this expense.
Convert Fixed Expenses to Variable
The best approach for managing capacity and for growth is convert Fixed Costs to Variable Costs.
How to do that?
Ask more questions:
- Do you need an office at all? Can your team work from home as effectively? Can you downsize your space? Or sub-lease?
- Can you convert employees (usually your biggest expense) to part-time employees? Can you outsource the work done by employees? That would convert that large expense to a variable one.
- Can telephone contracts be renegotiated?
- Can you partner with suppliers to pay them a volume type incentive rather than a fixed fee?
In Conclusion
Finally, remember to review your Fixed Costs on a frequent basis, even monthly.
A closing example is looking at software costs. These can get sticky. Often, we pay for needed software as a service. We stop using it, and we forget to cancel. So, it is a good idea to at least review these types of sticky costs monthly.
Thank you for reading…
by MHolland | Feb 9, 2024 | Business Tips, Systems
In the beginning of every New Year, most people set goals. By February – now – they are usually forgotten.
On the other hand, habits create results.
Even micro-habits (more on this later) can completely transform your business, and your life.
For years I have been using a life-changing software app on my phone called Loop Habit Tracker. (This is an Android app, and, sadly, I do not think that it is available in the iPhone Store).
How Does Habit Tracker Work?
It is super simple, yet do not let that fool you. Simple is better for habits. Complex means you will rarely do it, or inconsistently do it.
First, you create a habit in the app.
It can be a “yes” or “no” type habit, or it can be a measurable habit.
A “yes or no” type habit is simply did I do it, “yes,” or did I fail to do it, “no.”
An example is “did I exercise?” Yes, or, no?
A measurable habit is, for example, how many kilometers did I walk today? And you track your daily results from zero to the number you walked.
Simple, yes?
Does This Really Work? Come on!
I have some habits I am tracking that I have not missed a single day in years!
It took time to develop consistency and what motivates me is the visual disappointment in seeing unchecked habits.
Habits are activities that you do, and what you do consistently over time will create the desired results.
When a person creates big goals, they can have this short-term adrenal rush of imagining the massive results that will emerge from these BIG goals.
Perhaps your goal is to get super fit in six months, so you tell yourself you will do a 90-minute intense workout every day.
Then, as usually happens, life gets in the way. You cannot find ninety minutes every day, especially on busy days. Or sick days.
On the other hand, when you start small you create the habit first! Then you add a wee bit more. See how that goes. Then a wee bit more. Soon you are habitually doing what you wanted to in the beginning.
And here is another thing to think about. The habit is much greater than short-term bursts. For instance, I read the other day that moderate exercise is healthier than intense workouts.
Consistency trumps short-term blasts.
The Secret Ingredient Is…
The key to success with habits is this – start small.
Even tiny. So tiny it seems, well, even ridiculous.
It is like Kaizen, the Japanese technique in manufacturing of constant and never-ending improvement.
Small, daily movements towards excellence creates long term results in a more measured, stressless, consistent fashion.
I recently read about a woman who now does one hundred push-ups every single day.
In the beginning of her habit creation, how many do you think she did?
Five. Just five. From there she added more and now does one hundred each day.
How Many Habits Should You Track?
This is a great question. I am glad you asked…
I only track ten.
I chose them this way:
- Do I do the habit anyway? Is it already ingrained and does not need documenting? I do not need to be reminded to brush my teeth as an example!
- Is it important to me? Will this ingrained habit change my life? An example is daily workouts. I have not missed a day in years.
Should I Stop Tracking This Habit Once It Is Engrained?
I do not stop if the habit is that important to me. For example, I know that if I stop tracking my workout, I will not do it daily. I will make excuses on busy days.
How Does This Apply in Business?
Here are the key questions to ask yourself…
- Will this habit transform my results? In other words, will this habit, done daily, over time create remarkable results for my business?
- What do I procrastinate on that is profoundly important for business success?
- Is this activity “important, yet not urgent”? Think of activities that if you do not do, nothing bad will happen in the short-term. An example would be making outbound calls. You may not lose any of your current business, yet long-term your growth might be stagnant.
To start, only track 3-4 habits. Make sure to pick the most critically important activities in your business.
Here are some simple examples to help you get started:
- One call to one Team Member per day
- One call to one client each week
- Block 90 minutes of focused time for systems work three times a week.
- Write a blog weekly.
In Conclusion
To dive deeper into the impact of micro-habits and how life changing they can be, please read this blog:
https://freedom.to/blog/micro-habits/
Thank you for reading…
by MHolland | Jan 31, 2024 | Business Tips, Cash Flow
Accountants should not be responsible for setting pricing.
Why not, you ask?
Because most accountants will focus on all your costs (inputs) and add an acceptable mark-up to get to the price.
Here is the problem – customers do not care what your costs are. Why should they? You could be running a very inefficient business with wages that are too high, rent that is too high, and so on.
Costs Do Not Equal Value
Let us look at a car example. It likely costs more to build a Mercedes than a Ford Fusion. Yet, not that much more. In other words, the mark-up on the Mercedes is greater than on the Ford Fusion for the intangible value that the customer places on that 3-star symbol on the hood.
In today’s outsourced manufacturing environment how does a business add value in unique ways to get a higher price?
It seems like everything is a commodity these days. How do you do value pricing when you are selling a commodity?
See It Through the Eyes of Your Customer
This is where, again, you must look at your product/service through the eyes of your customer.
Ask these questions:
- What elements of your product/service does your customer value?
- For example, can you deliver the commodity you sell more quickly than your competitors?
- What about after-market service? When the commodity product breaks down, what does your customer do? What expectations do they have? You could offer awesome after-market service for a price. You could build it into the initial pricing.
- What is a frustration that ALL customers have in your industry? It could be delivery times. No after-market service. Slow service. Indifferent, non-caring attitudes from order takers. Solve this big problem everyone has, and you are now differentiated. You will stand out from the crowd.
- What can be bundled with your “commodity” to add value and create something unique?
An Example of Fixing an Industry Wide Problem
In the accounting industry almost, everyone charges by the hour.
So, the client never knows what the ultimate bill will be until the work is done. All the risk is borne by the customer.
Most clients hate hourly billing. They hate it because they never know what they will pay.
This is where Fixed Pricing comes in. You work out what the value is to the client for the work to be performed and then set that price. You get the client to sign that agreement. The client will then hold you accountable for the results that you are committed to deliver.
All the risk is borne by the seller now. If you are inefficient, you will make less profit. Conversely, the rewards are all with you as the seller now too. If you take less time to fulfill on the promised results, then you will have more profit. (The client does not care; they agree to a Fixed Price and the inputs are not relevant).
Fixed Price Agreements transform something that most clients find annoying, irritating, or downright unfair into a competitive advantage.
How To Turn a Commodity into a Rarity
Again, let us again use the accounting industry as an example…
A tax return could be seen as a commodity now. It is just entering your slips into a tax software program, and the result is spit out and you either pay tax or get a refund. End of story.
The cheaper the tax return the more you save.
Why would you pay more? Where is the value add?
Okay, this is where bundling can come in handy.
You look at all the services you offer as an accounting firm – wealth planning, and retirement planning as two examples.
You create a bundle of services that includes:
- Retirement planning
- Guaranteed tax return. If the IRS or CRA sends any correspondence to you regarding your tax return that year you will handle it free of charge. In other words, audit insurance.
- You provide free phone calls on any tax matter coming up during the year.
As an example, let us imagine that the tax return is only worth $75. However, the entire bundle mentioned above is worth $1,000. Not all the clients of the firm will pay that. Many will, and the profitability could be much, much higher.
The above example could apply to most professional service firms, and even blue-collar industries like electricity and plumbing.
For example, a plumber could charge a fixed maintenance fee to cover a set of deliverables including annual maintenance that many people would happily pay extra for.
In Closing
Think about, in your industry, a problem that everyone has with your industry. (You may need to ask your customers). Solve that problem and change your prices accordingly.
Lastly, think of how you can use the concept of bundling to add value and increase your pricing for a bundle. Insurance or guarantees are a great way to add value.
Thanks for reading…
by MHolland | Jan 26, 2024 | Business Tips, Systems
A few years ago, I wrote the following blog on systems. I am re-printing it as it is even more relevant now, in 2024.
Without systems, there is no consistency, no duplication, and no training. The customers get different results from different people and at various times. It is impossible to grow because without systems there is no duplication.
“Organize around business functions, not people. Build systems within each business function. Let systems run the business and people run the systems. People come and go but the systems remain constant.” – Michael Gerber
Semi-Organized Chaos
Without systems in a business, you have semi-organized chaos. I have found in my work with hundreds of small businesses that it is the lack of systems that causes business failure more than any other factor. Lack of systems lead to other problems that are often identified as the problem when they are really the symptom. For instance, people often say poor finances led to the early death of that business. Or operational problems, or poor marketing. Lack of great systems is at the root of it all. (Of course, you still need a viable business model – selling snow skis in Morocco will not be a winner).
Some people hate the word “systems.” They want to be free. Free to create. Free to “go with the flow.” Freedom to “let their people figure things out on their own.” And, when things go wrong, they complain that “it’s so hard to find great people.”
Sports as Metaphor for Business
Sports is a fabulous metaphor for business – sporting games run on rules, systems, extensive training, and key metrics – just like a winning business does.
The other day, I read this funny story of what it was like for Nicky Gumbel refereeing a boy’s cricket game in England:
“I remember, years ago, a football match that had been arranged involving twenty-two young boys (including one of my sons, aged eight at the time). A friend of mine, Andy, was going to referee. Unfortunately, by 2.30 pm he had not turned up. The boys could wait no longer.
I was press-ganged into being the substitute referee. But I had no whistle, there were no markings for the boundaries of the pitch, and I did not know the rules as well as some of the boys.
The game soon descended into complete chaos. Some shouted that the ball was in. Others said that it was out. I was not at all sure, so I let things run. Then the fouls started. Some cried, ‘Foul.’ Others said, ‘No foul.’ I did not know who was right. So, I let them play on. Then people began to get hurt. By the time Andy arrived, there were three boys lying ‘injured’ on the ground and all the rest were shouting, mainly at me!
But the moment Andy arrived, he blew his whistle, arranged the teams, told them where the boundaries were and had them under complete control. The boys then enjoyed a great game of football.
Were the boys freer without the rules, or were they in fact less free? Without any effective authority, they could do exactly what they wanted. But people were confused and hurt. They much preferred it when the game was played according to the rules. Then they were free to enjoy the game. The rules of football are not designed to take away the fun of the game. They are designed to enable the game to be enjoyed to the full.”
So many businesses are just like this – semi-organized chaos. No rules, no systems, no order. Just people trying to figure out (each in their own way) how to get things done.
No Systems Make People Sick
In sports, as in the example above, people get physically hurt without boundaries. Do they get hurt in business with no boundaries?
Yes, they do. From added stress, sickness from over-work, anxiety. In-fighting. Blaming people instead of the system.
Without systems, everyone must make it up. Here is a simple example in my own business. I am a real stickler for the details in providing awesome service to our clients. As a virtual business we communicate a lot with emails. Without any Performance Standards (read, systems) each person just adds their own “style.”
Freedom of expression, right? Perhaps…
Our Email System
In our email system we sprinkle “softeners” throughout the email to inject tone in a toneless, flat form of communicating. Words like, “kindly,” as in “would you kindly confirm whether 3pm, Friday works for a quick call…”, “good morning/afternoon/evening”, “thank you”, “I was wondering if you would mind…”.
We do not use abbreviations. Have you ever got an email with a 3-letter abbreviation that you have no idea what they mean? I have…
We do not use loads of “happy faces” – yet one per email acts as a softener.
If I were to remove the names from a few emails in our company, you would have a tough time figuring out who wrote it.
This provides a consistent level of showing we care through that medium. It is a system, complete with Performance Standards.
What Should You Systematize in Your Business?
Start with the things that matter most to your customers and your Team. Think of your Team as a well-oiled machine as in a sports franchise. Give your “players” all the tools, training, coaching they need to perform as the stars they are.
Never blame a person, always blame a “system,” or lack of systems.
And, with great systems, you now have a means to counsel people out of your business, if they refuse to play by your “rules of the game.” Without systems you will never know if people just needed boundaries and training to excel.
People want to naturally do good and excel. They just make it up as best they can. Then bad owners blame them because they did not do it “their way.”
If you want duplication and consistency, give people a system to follow.
If I have a system, doesn’t that mean my people will become bored robots?
If you think that, let me ask you a question – did Wayne Gretsky, arguably the greatest hockey player of all time, operate inside of strict boundaries and rules as a hockey player? And did he display creativity and amazing capabilities inside of these rules?
People excel inside of rules, standards, systems, boundaries, not outside them. It is what makes a country work, a sports game, a community group, and it is what will make your business really soar!
Thanks for reading….
