On today’s episode we’re going to talk about numbers. I have worked with hundreds of entrepreneurs over the years and the successful ones have a few things in common – basically that they understand the fundamentals in business and understanding your numbers is one of the fundamentals.
Most entrepreneurs I’ve worked with over the years focus on a few numbers. Generally, every entrepreneur focuses on two numbers, they focus on 1. Profit and 2. Cash in the bank. Taken on their own, these are two of the most dangerous numbers in business. When taken without context, these two numbers, which most business owners focus on, will lead them to never getting what they want from their business, or worst case, to business failure.
In this episode of Your Business Unleashed, we’re going to talk about adjusted net profit, and how it is different from profit, and we’ll discuss the 5 stages of accounting focus as your business evolves.
Adjusted net profit
Whenever we think about financial success in your business, it is important to think about your business through the eyes of a potential buyer. What financial metrics would someone want to know if they were evaluating your business? Often times, businesses are valuated for sale based on a multiple of EBITDA, or earnings before interest, tax, depreciation and amortization. A buyer will take your profit and adjust out these expense items and then normalize the owners salary to arrive at a profit number that they can apply a multiple to. For our purposes, let’s just focus on the normalization to arrive at what I call Adjusted Net Profit.
So “Profit” (from the perspective of the business owner) is often very different from “Adjusted net profit” (from the eyes of a potentially buyer). Adjusted net profit is the number that allows us to live our ideal lifestyle, which I talked about in episode #1.
To arrive at adjusted net profit, you take whatever your accounting profit is and deduct the salaries of all the positions that the owner is performing in the business to ensure its stability. A lot of businesses don’t pay themselves a salary, or they don’t pay themselves a market rate salary for the various jobs that they are doing for the business. They simple “accept” to be paid “whatever is leftover” after the business has paid its bills.
This is backwards thinking for a number of reasons. The main one is that most entrepreneurs in the world don’t actually have a business, they own a job. Usually, one that doesn’t pay them very well for the efforts they contribute, certainly not the market rate wage that someone else would pay to do the same job(s). When we think about profit, the first expense item we should think about is paying ourselves a market wage, and then reverse engineering our profit and loss statement, from all the And then they’ll normalize this version of ‘profit’ for unusual items like how much salaries are being paid to people related to the business.
In order to have a real gauge of your businesses profitability, you have to estimate and accrue in market rate salaries for all the positions you’d have to hire to replace the owner. Most small businesses, when viewed this way, aren’t profitable at all.
When we started this exercise at my accounting firm, Achen Henderson, we realized that we needed to hire an administrative assistant, an office manager, a marketing person, a staff accountant, and a manager in order to replace myself. That was approximately $370,000 in salaries that we needed as a baseline in order to start getting some freedom from my business. That is, we needed $370,000 in salaries for our business to start providing us with our ideal lifestyles, $370,000 was the market rate for all the things we were doing for the business.
Our profit on the financial statements at the time was somewhere around $250,000 / year and we weren’t taking a salary, we were taking dividends. This means that our adjusted net profit was negative. We didn’t have a business; we were a slave to a business. We had bought ourselves a job, and one that paid us below market rate compared to if we just went to be an employee somewhere.
If we actually think about it, this means that most small business owners, including us, accepted that financial hardship was was simply theearning below a market wage, is simply the cost of having freedom. This is ridiculous.
We thought about the adjusted net profit of Achen Henderson in terms of selling the business. A reasonable buyer would almost certainly perform this ‘normalizing’ exercise on our profit number, definitely if I were helping them with the transaction. A buyer would quickly realize that without significant inputs from the owner, that is if the business had the staff it needed to run independent of its owner, the business wasn’t profitable. This would significantly diminish the price that a buyer would be willing to pay for the business, if they would buy it at all.
Why is it important to think this way? A reasonable buyer doesn’t want to buy themselves a job, they want a business that will provide them with freedom in the form of time AND money. Richard Branson and Warrant Buffet don’t buy companies so they can work in them. Down here on earth, my most successful small business clients do not work in the day-to-day operations of their businesses. That is, if they stopped showing up for 6-months, their business would continue to function and produce profit for the absentee owner. This isn’t a rich business owner’s game, it’s an intentional business owner’s game. All of us can live in this reality, given some intention, time, and focus on the business fundamentals.
Back to our experience at Achen Henderson: We quickly learned that it was time to start hiring people in a strategic way that would allow us to grow revenues to cover their salaries. This is where the concept of ‘leverage’ comes in. That is, if you hire strategically, and in the right order, you should be able to earn significantly more revenue with the hire than their salary cost. This is something we talk a lot about in my 3to5 club, a CEO Mastermind that I facilitate.
We’re still hiring to replace the owners and we are close to $1M in salary costs. Now, Achen Henderson generates enough adjusted net profit that the business is actually a business and not just a job for the owners. That is, if we were to hire out the last few operational jobs that we do day-to-day, there would be some adjusted net profit left over for the owners.
That’s adjusted net profit.
KTA: Your salary is not profit
Here’s a key takeaway: your salary is not your company’s profit, it is a component that goes into calculating if your business is profitable or not, but simply accepting whatever is left is not a good measure of the profitability of your company.
5 Stages off accounting focus
One of my mentors and podcast guest, Chuck Blakeman, introduced our 3to5 Clubs to the idea that there are 5 stages of the relationship that every business owner has with their accounting, as their business evolves. Listen to these stages and try to determine which stage you’re in.
Stage 1 Revenue: Revenue. If you don’t have it, there is no other focus. This is what we all have to focus on when we’re getting going. At Achen Henderson, we help a lot of small businesses that have never earned enough revenue to cover their basic expenses. This is, frankly, the definition of insanity because it continues for years. These business owners are often a complete mess in their personal lives, perhaps the venture has lead to divorce or a loss of personal assets. They need sales. This isn’t the time to think about how to save 20% on marketing expense or what expenses can be cut. Sales are the only thing we should be worried about in stage 1.
Stage 2 Profitability: Once sales are ticking along, the business owner needs to focus on the ability for the business to be profitable, that is, the company’s profitability. This is different from profit. Put yourself at a market rate salary, figure out the minimum amount of expenses you need to become profitable, model it, and figure it out. If the business cannot be profitable, you don’t have a business so stop doing it or raise your prices. Back to stage 1 revenue.
Step 3 Profit: Congratulations, you’re earning enough revenue, and you’ve executed your profitability plan, and now your company is earning profit, including your salary. This is a wonderful stage, but one where you start thinking about how much profit is enough, which is stage 4.
Stage 4 Growth: You’ve proven that your business can make a profit and be profitable, how much further do you want to go? How much is enough.
A great book to read here is called Small Giants: Companies that Chose to be Great instead of Big by Bo Burlingham (check title). This book is a great guide for entrepreneurs trying to figure out what they are actually going for, how much is enough. Another great resource is my early podcast on your companies Big Why.
The Growth stage can be the most dangerous stage. Why? Because Cash flow is super hard to manage during the growth stage. Growth consumes a lot of cash in a couple of key ways:
- First, cash expenditures for capital items aren’t directly reflected in your profit and loss statement, like buying equipment or office space. 2021 was a very expensive year for Achen Henderson because we bought and furnished a brand-new office. A lot of this was done with debt, but a lot of cash was required as well.
- You have to hire people and spend money on resources ahead of their growth curve. That is there is a lag time between when you spend money on resources that do hit the profit and loss statement, like salaries, and when you can increase revenues sufficiently to cover and make profit from those resources. 2022 was a very expensive year for Achen Henderson because we increased our salary load by nearly 60% in order to ‘hire ahead of the growth’. We had already experienced what it felt like to hire people when we ‘needed’ them, which was always too late and inevitably lead to the owners working to hard filling in the gaps. We agreed to stop doing this, and start hiring ahead of the curve, which is tricky to do and we’re constantly improving the way we approach this.
As chuck says, “we burn a lot on takeoff”, and I think this also applies to growth. The faster you grow, the less money you’ll have. I’ve seen a lot of business fail when they were trying to grow because they simply ran out of cash. Amazon wasn’t profitable for its first several years, in fact it operated at a serious loss. But it had cash flow because enough people were willing to continue financing the model. Growth is expensive and dangerous. Decide how much is enough.
Stage 5 Expenses: The final stage. Once you are comfortable with how much you are making in terms of top line revenue, now, and only now, we can start focusing on making more money by becoming more efficient and reducing expenses. You should not fixate on cost controls before this stage. A very large percentage of small business owners that I’ve worked with focus on Stage 5 right at the beginning, even before they have revenues, certainly enough revenues to pay themselves a market rate salary and this is backwards thinking.
Expenses are scary and we’re constantly hunting, we still have a hunter gatherer mindset, so we’re fixated on cost controls even before we have a viable business. We think this way because, as entrepreneurs because we think that every dollar that we spend comes off our dinner table. We’ve certainly done this at the accounting firm, hiring people too late in the growth curve because we were worried that their entire salary will come our of our paycheques. We view it as a hit to our family rather than a planned hit to the budget. In truth, that’s rarely the reality. In fact, we miss a lot of opportunities to grow when we think this way. If we stick to the fundamentals and we are growing properly, spending money will almost always help us grow.
I once knew an entrepreneur who bought a business and then she worked so hard in it and focused so intensely on controlling expenses that she turned 70 one day, trapped and not able to retire. Further, she had ground the business she bought down to a shell of its former self and worked so hard in the business that she was, irreplaceable and so she had no chance of selling her business. She quite literally trapped herself in her business by focusing on controlling costs before she had the revenues, profit, and growth to enjoy business ownership, and spent her life savings doing it. I cannot think of a sadder situation in entrepreneurship, I really felt bad for her when I did her taxes every year and watched as she declared a very small dividend to herself that barely, if even, covered her living expenses. Don’t focus on stage 5 until you get there. It’s a bad idea every time.
Understanding your businesses’ numbers is one of the business fundamentals, and a commonality between all successful entrepreneurs that I’ve worked with. Have a good look at your profit and loss statement with your accountant and normalize it for all the inputs that you contribute to the business to determine if you actually have a profitable business, or if you have simply built yourself a job. Constantly analyze which phase of accounting your business is in so that you can stay focused on what’s important, revenue, profitability, profit, growth, expenses. Addressing these out of order leads to very dangerous results, doing it in the right order, while sticking to the fundamentals, will help you get the freedom that you wanted when you started your business.
Show notes:
Book Recommendations: Small Giants by Bo Burlingham