We get it. You might be one of those CEOs who is very good at selling and is always tempted to get the next deal, because it feels thrilling, right? But what about profitability? What if this deal is costing your business an arm and a leg?
In this blog, we look at:
- Why this happens?
- How to go about creating the financial discipline you need to achieve financial success in your business?
Recently, I thought to myself, “What do my clients have in common with one another?” so I decided to analyse them a bit.
It turns out that around 80% are family-run businesses. What else? Around a quarter are businesses run by sales-focused CEOs and two-quarters are run by operations-focused CEOs.
Then, I went on to compare how are they doing performance-wise. The sales-focused CEOs are growing their businesses faster and profitably. The operations-focused CEOs are better at optimising what they’ve got, therefore - grow slower, but still, maintain their profitability.
For both of them, maintaining a certain level of financial discipline is the key to growing a profitable business. Even though it might not come as naturally for the sales-focused CEO as does for the operations-focused one, with the right tools, financial discipline can be achieved easily.
This is how it works.
Financial discipline refers to the ability to stick to the plan you have set for the business regarding the generation, spending, distributing, and retainment of money. It is a continuous process that should evolve as the priorities of the business change over time.
First, you need to create a financial plan. In order to do so, you need to set a clear goal and establish your targets. A target is a specifically defined goal you want to reach.
Everything starts with the end goal in mind. What do you want to attain in 1-2 years from now? We spend a lot of time looking for next year’s targets and yet we often miss them. Why? Because they are either unrealistic or they don’t consider essential data such as money for taxes, dividends, money for working capital, etc.
Our favourite tool to use on our Cash Flow Improvement app is the Money Multiplier for CEOs. This tool is not only useful for setting performance targets, but it is also extremely powerful for exploring "what-if" scenarios. It shows you exactly how potential revenue growth will impact your cash flow and the bottom line.
Here’s an example.
You simply input the numbers for your last 2 financial years and the app generates your results. It's as simple as that!
Note: The MMC tool has already taken your operating model into consideration when producing the results. It is also converting the numbers into the key ratios that you need to track so you can see how much money you are making for each 1% change or 1-day change of the key drivers of your cash and profit. This is the secret that sets smart CEOs from the rest.
From here, you can start with what you want to spend money on, in addition to what you are already spending. From our experience of working with entrepreneurs, we have learned that this is where most entrepreneurs want to start from and work their way from there. The thing most entrepreneurs want to spend money on is people, so they can get the work done!
People are classified as a direct cost if it's direct labour. Or as overheads, if it is management labour.
Next, your plan needs a forecast of how to get to the target. Contrary to a target, a forecast is planning ahead to predict a course.
The traditional way of forecasting has never really worked for me... I remember when I was trying to reach the forecast, together with my fellow management team, that it was always a way way out of reach. It made me feel overwhelmed to the point that I stopped believing in it. You could be very eager and excited about the targets and the company’s goals, but if the forecast is done badly, then you are never going to reach your targets
There is no need to go by the calendar or the accounting year. It is best practice to have a 12-month rolling view of your plan. Once you know your target, you can build a weekly, monthly or quarterly plan of how to get from one point to another. Sometimes you may get to your target sooner than you have planned and sometimes it may take longer. It is fine, either way, as long as your plan is still realistic and it still takes you to where you want to be.
There are two traps to avoid in this process. One is to make sure that you take into consideration the ramping effect of what you are currently doing. For example, if you want to grow your revenue by 20% in the next year, factor in the time it takes for the new initiatives to come through. You might not see the effect of these new sales initiatives in the first 6 months. However, you can reflect the effect in the following 6 months by increasing your sales forecast by 20%-30% so that it averages 20% within the 12 months’ period.
The other trap that's easy to fall into is the one of unproductive activities. When we focus on the monthly incremental planning, we often miss the bigger opportunity of stopping unproductive activities, so keep your eyes wide open for this!
Next, you will need to evaluate the plan. How realistic is it? To evaluate your plan you need to consider these factors:
The maturity of your market. Is your product or service satisfying customer needs in a mature market? If yes, you might be now focusing on maintaining your position in this market and investing in minor improvement initiatives until you are ready to make your next major market move.
Company performance and labour productivity. Is your company trying to maintain its performance or improve it? Is the plan helping you get your goals?
Return on your invested capital. This is so important and often overlooked by founders.
Now comes the difficult part: building financial discipline. We live in a time of instant gratification and it is hard to deny yourself certain things. However, if you want to be stable financially, you must learn to manage how you spend money.
What do I mean by that?
Let’s face it, we don’t really like spending money. Most CEOs I've worked with, when it was time to sign the cheque, they made sure that they delayed it as much as possible. They would ask all sorts of questions just to make sure that payment was made for the service that lived up to the expectations.
So it is very important to make the payments with ease and appreciation for the product or the service that was received. Each time you have a knot in your gut it means that something is not right and you will need to make sure that you make some adjustments internally to bring the satisfaction levels up.
Inspired spending is what opens the door to more coming in. The more compliments you offer, and you really mean it, the more come back to you.
Another important factor in building financial discipline is to see your financial plan as something that is expanding and make your decisions from there. If you are feeling guilty for spending more than you have budgeted for, you will never expand. Instead, think of your revenue as something that is expanding, so the spending follows to match that expansion.
The Money Multiplier for CEOs is a really useful tool for helping you keep up with this expansion and helping you see how to grow and create cash flow and profit. Make sure to try this easy 5-step approach to help you create financial discipline in your business:
#1 Fix your profitability
If you have been profitable for a number of years, then your next move would be to keep discovering ways to boost your profitability, say from 5% to 10% or from 10% to 15% for example.
If you are already making 15%+ after-tax profit, then discover which product lines or markets this profitability is coming from and replicate the same model elsewhere.
If you are operating at a loss, then the first step for you in creating your financial discipline is to fix your profitability. If you are not getting enough business, you need to look at your strategy. After you have fixed your profitability issue, move to step #2.
#2 Set aside money for taxes
Thinking that you can use the cash for taxes to make more money or manipulating your financials to avoid paying taxes will not get you far.
Money for taxes isn’t your money. Therefore, you should aim to set aside cash each quarter for your corporation tax. It is amazing how fast one year moves and it won’t be long till your annual tax payment is due.
#3 Get rid of debt!
Those of you who've been in contact with us are aware that we are genuinely not fans of debt. If you have one, you should put your focus on getting rid of it. Debt requires management and should be a temporary solution only for managing your cash flow problems.
If you are losing money and you have a line of credit, it is easy to draw on it. But banks know that sooner or later you will run out of cash and you will have no funds to repay the line of credit. So focus your attention on fixing your profitability.
#4 Build your Core (Vital) Capital
Your core (vital) capital is defined as 2 months’ worth of operating expenses plus the cost of direct labour. If you get any terms for your direct costs or costs of goods sold, then remove them from this amount. Having this capital helps you navigate your way out of the bad quarter and protect your margins. You won't have to compromise your profitability for cash and most likely you will never want to see a line of credit ever again!
When you have achieved your core (vital) capital target, you can move to the last step.
#5 Pay dividends
Dividends shouldn’t be seen as financing the living costs of the owners, as it is in most cases. Rather it should be seen as a reward for owning a cash-generating and profitable asset - a high-performing business!
Start paying dividends only after the above 4 steps have been accomplished successfully. If you do it prematurely, you will cripple the business from fulfilling its potential and generating the required return on capital for you and all interested stakeholders.
We cannot emphasise enough the importance of financial success for your business. Smart CEOs use the numbers from the most recent financials to forecast the future and to make better management decisions going forward. They also keep making adjustments to their plan so they can get to their target faster.
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