Once revenue increases, entrepreneurs no longer have to worry. Correct? After all, the market has confirmed that its business model is solid. What could possibly go wrong?
Well, in fact, many things can go wrong. One of my late father’s favorite sayings was, “The greatest cause of business failure is success.”
Entrepreneurs unprepared for the challenges of business growth can often derail even the most promising business model.
So how should you plan for growth?
The first step is to make sure how big your business really should and must be.
Reverse income statement
The best tool I’ve found for smart growth planning is to use something called a bottom-up income statement. Rita McGrath and Ian McMillan named the process Discovery-Driven Planning in their classic article on the technique First published in 1995 in HBR. (Here is a newer summary of this class article). I learned it from my late father in the 1970s.
The basic logic is this: start with how much you want to make as you plan to grow your business.
Let me offer an example based on using this tool to help my daughter, Maggie, and son-in-law, Matt, figure out just how big their commercial painting business can grow. Harpeth painting.
Matt had booted Harpeth Painting. At first, Matt kept his job with a commercial construction company to support her family. He worked on the new business mornings, lunch breaks, nights and weekends. After identifying a niche market and doing the startup well, the company grew steadily for the first year.
Right on the first anniversary of Harpeth Painting’s introduction, our daughter gave birth to her third child. Harpeth Painting was fine. His cash flow was making up for the salary he had earned and they had amassed good cash at the new company.
Maggie said, “We have three children now, including a new baby. It’s time for you to just work one job! “
So Matt took the leap of faith and quit his “day job”.
How big is big enough?
Three years after the company had grown, Maggie came to me wanting help figuring out how big they were to grow the business. It was going well, but they just weren’t sure how far to take his growth. They had no real aspirations to build an empire or even a big company. They just wanted to earn a financially stable living with it. The business had grown to around 25 painters. Any major one would require them to start investing in a few administrative positions to help them out.
Maggie and I met in my office and began developing a financial model for their business.
Step 1: what are your financial needs and goals?
I asked Maggie how much they would have to take home each month to live comfortably. The company was already generating enough income that that number was their current personal budget. We just added a little to this number for pillows.
Next, we added income tax to that number since your company is an LLC. We’ve also added a little extra to this estimate.
Finally, I asked what they wanted to save each month. Your business will be of little or no value when you are ready to retire. If one day they have equipment or even a building of their own, it has value. But Matt is the business. All of the work they get is based on his relationships. That means any savings for retirement, college, etc., etc. must come from the company’s cash flow over time. Maggie gave me her target savings, which was a fair amount. I doubled it!
We now had the foundation of the financial plan to guide the growth of your business.
Step 2: overhead
Your business has a pretty simple overhead structure. Matt and Maggie both pull a paycheck. The company rents space for trucks, equipment, inventory, and an office for Matt. You have a couple of people in your salary. We also added marketing, insurance, etc. They are both dedicated bootstrappers (the apple won’t fall far from the tree for either of them) so their overhead was reasonably priced.
Sometimes when I do this technique I find a lot of bloated expenses in a company. Not this time!
With the overhead and what they need to get out of the business, we now know how much gross profit (sales minus variable costs / COGS) the company needs to make. Add up everything we have so far and we have that goal for gross margin required.
Step 3: Required Sales
To determine the revenue needed to meet the owners financial goals, we use this formula:
Required Sales = Required Gross Margin / Gross Profit Margin
Let’s look at this with completely hypothetical numbers.
- Overhead = $ 20,000 per month
- Required Income for Owners = $ 10,000 per month
- Estimated LLC pass-through income tax income = $ 5,000 per month
- Estimated Monthly Personal Savings Goal for Owner = $ 5,000 per month
Gross Margin Required = Overhead Costs + Profit Target + Taxes + Savings Target
= 20,000 + 10,000 + 5000 + 5000
Gross Profit Margin = 20%
Required turnover = 39,000 / .20
= $ 200,000 monthly income
For this hypothetical example, the company would need to have approximately $ 2,400,000 in annual sales to meet all of the owner’s personal goals out of business.
“So we don’t have to grow anymore ?!”
When I did this with the actual numbers from Harpeth Painting, Maggie was delighted. As it turns out, the current size of the company is 50% more than what they need to be in order to achieve their goals.
This was great news as they had just met their two bosses and they all agreed they loved the current size of the company.
Step 4: how much cash?
Maggie’s next thought was that she wasn’t sure they were going to take out enough money to still meet their savings goal. Their business model required providing cash upfront for jobs, and they would rather not do this with their line of credit unless absolutely necessary.
So the final step was to determine how much cash they would need as the average balance to meet the company’s working capital needs.
My rule of thumb is that every business must aim to run cash for at least 30 days. This means that if no cash has been received for 30 days, there will be enough cash in the bank to cover this period.
Given the cash flow challenges of a commercial painting company, I recommended having at least 60 days of cash on hand, and 90 wouldn’t hurt. Personally, I believe six months would not be an excessive sum.
Some argue that this is poor asset management since cash really doesn’t make any money. If I have cash in the bank, I can sleep well at night. That is a value that is much higher than any interest I could earn.
Moral of the story
Rather than growing the business simply because you can, know how big it has to be to meet your short and long term needs. Life is short. Life is more than running a business. Do not get me wrong. I love being an entrepreneur. But I also love being a husband, a father and a grandfather. We love to travel (hopefully soon), I love golf and I love hanging out with Ann. All of this requires planning if you are a business owner, and the bottom-up income statement can help !!
Note: We are not the author of this content. For the Authentic and complete version,
Check its Original Source