How the Balance Sheet is the Gateway to Greater Profitability
Updated: Apr 12, 2021
For anyone who loves watching Shark Tank as much as I do, you know that it doesn't take long before questions on sales and margins start coming up. And for most business owners, this is where most of the financial thought goes. Don't get me wrong. These are very important numbers to know, but there is a whole other set of numbers that don't get enough attention from most small businesses and startups.
How often do you think about your balance sheet?
For those who aren't familiar with all of the accounting lingo, the balance sheet is the financial statement that provides a snapshot in time of the financial health of your business. This is the statement that shows how much cash you have, how much inventory, how much do people owe you and how much do you owe others. Managing towards a healthy balance sheet is extremely important because it sets you up with having a solid foundation to build on.
You can think of it in terms of personal finance. If you have a lot of debt, little cash saved and are living paycheck to paycheck, it is very difficult to build wealth. You can't invest towards progress and you can't take advantage of buying in bulk. Usually the first thought that we have when we're in this situation is "I need to make more money." And while that may be a factor, this predicament happens to people in all income brackets. The problem isn't always to bring in more money. Sometimes the problem is simply that we are lacking a system to control our spending. And the most basic starting point is to simply start setting aside a little bit of everything that comes in. You need to save.
The same is true with business. When the profit isn't there, the first thing we think is "I need more sales!" But while more sales can be a good thing, is that always the case? The answer is surprisingly no.
Not every sale is created equal. I learned this in the early days of operating Nordic Jo's Coffee. When I first started, I wanted to be able to offer every coffee product out there. I was chasing sales volume. The problem though was the costs and inefficiencies that came with that. At one point I was pursuing a diner as a potential customer. Diners go through a lot of coffee of course, so it seemed like a great idea. The challenge was that the diner wanted their coffee in portion packs so that they didn't have to scoop and measure the coffee out each time they had to brew a pot. So, I went to work figuring out how I could provide that and was able to find a solution through a co-packer. Problem solved, time to make that sale, right? Not exactly. I could offer the packaging style now, but the co-packer's minimum production run was more than what my single diner customer would consume before the product went stale. So, that meant that I needed more customers to buy that product. It ended up not working out. Luckily, I learned early on a small scale.
Now here is where balance sheet health comes in. It wasn't necessarily wrong for me to have tried pursuing diners as customers. After all, nothing ventured, nothing gained. I was just doing things in the wrong order. The right way for me to have gone would have been to exercise a little patience and use my existing successful product line to strengthen the health of my balance sheet. In other words, I should have kept my focus on what was already working and worked to save up cash before taking on the inventory risk that came with that sale. With sufficient cash reserves, I could have bought time for myself by being able to afford to let some inventory go to waste while I found enough customers to make the product line viable rather than having to go into a mad scramble. Or maybe even better yet, I could have invested in my own equipment, so that I wasn't bound to the minimum run requirements of a co-packer.
This is really just one way that a healthy balance sheet can lead to greater profitability. Since I started out with sharing one of my personal failures, I'll take a moment to pat myself on the back and tell you about one of my personal successes. While launching my second business, Gambit Profit Consulting, I entered into a contract with a professional service provider that I hoped to be able to leverage to be able to provide greater service to my clients. This time, thanks to the cash management skills and knowledge that I had developed though operating my first business, I was able to not only afford taking that chance, but was also able to negotiate a 15% discount because I was able to pre-pay for the entire contract period. Having a healthy balance sheet with sufficient cash reserves gives you the ability to gain profitability by leveraging your strong cash position in negotiations that cut costs.
Every contract negotiation comes down to three basic elements; the deliverable, compensation, and risk. When a vendor takes on risk, they need a premium of sorts to be applied to the compensation. They need a reward for that risk. So any time that you, as a customer, can remove risk from a vendor, there should be an opportunity for a discount.
Very recently, I had a conversation with a green coffee bean supplier on this topic. I was seeking to gain a better understanding of what is important to green coffee suppliers when they are selling their products to roasters. What I was told was that it comes down to risk mitigation for them. When they extend thirty day payment terms, they take on a significant amount of risk due to the low margin, high volume nature of the business. Not receiving payment for a shipment can be very detrimental to the operation. This risk has grown over the last year due to the COVID-19 pandemic. So because of this, this particular supplier said that they are willing to offer discounts to roasters who are willing to pay upfront. So again, having a healthy balance sheet with cash reserves provides an opportunity to gain more favorable pricing.
So the benefits of having a healthy balance sheet are clear, but how do you go about accomplishing getting to that point. I believe that the answer is building a system that keeps you disciplined. The key is being mindful of where your cash is going. Every incoming dollar should be assigned a purpose and segregated according to that purpose. The first step should be simply setting aside a small percentage of each incoming dollar. Set up a separate account to keep that small percentage separated from the rest. This will start the process of building cash reserves. Over time, increase the percentage of your revenue that you are saving. Doing this will force you to learn how to be more and more efficient with your spending. Once you have mastered this first step, you can start further segregating your funds to specific purposes such as marketing, rent, labor, etc. This will tie your budget directly to the revenue that you are bringing in and help you from overspending in any specific category.
Another important step is tackling debt. When I started implementing this practice in my own business I was lucky enough not to be carrying a lot of debt. Still, one of the very first steps that I took was eliminating the debt that I had, and I made the decision to never carry a balance on my credit card, even if I was in the introductory period when no interest was being charged. The reason for this is that I didn't want a fluctuating credit card balance to mask how efficiently or inefficiently I was using the cash that my business was bringing in.
If you do have debt on your business, I suggest using the Dave Ramsey debt snowball method to eliminate that debt and free up cashflow. For those of you who are unfamiliar as to how it works, the idea is to pay off the smallest debt first, and as fast as feasibly possible. Once you pay off the first debt, you role the amount that you were paying towards it onto the next smallest debt. You continue through this process until the debt is eliminated.
Eliminating debt with this method brings two benefits. One of course is the reduced amount of interest that is paid by paying off the debt early. The second is that you grant yourself flexibility with your cashflow. Using the debt snowball method eliminates payments one by one. So if your business hits an unforeseen rough patch, you will be in a position where you have eliminated payments that you would normally have been making. Any cashflow that is going to paying down existing debts is essentially dead cashflow. It is money that has to leave your business without generating a benefit, so it is generally best to get rid of that debt as quickly as possible so that cashflow can start working for you again.
A third step at least for anyone selling a physical product is really taking a look at your inventory management. This is where things can get a little tricky when talking about the balance sheet. Technically, inventory is an asset, so larger inventory balances can make a balance sheet look healthy. I would argue though that the problem is that inventory really only is an asset if it can be quickly liquidated into cash. This goes back to the story that I initially shared about the diner. The excess inventory that I brought in beyond what was needed for that single customer was not an asset because I wasn't able to liquidate it.
This problem is not limited to just perishable products either. Every piece of inventory should be viewed as cash tied-up. It's a common problem that happens with many businesses. It might take the form of product lines that were tried but failed, obsolete items, or simply overstocked items. Overstocking can particularly be a problem in manufacturing. In manufacturing, any downtime is generally viewed as bad. However, if demand for a product is below a manufacturer's output capacity, overstocking occurs. This ties up cash in materials, and can even increase costs by created an environment that that requires more warehousing. Regardless of where your business falls within the supply chain, demand has to be the first consideration for inventory.
So if your business carries inventory, the first thing that I would suggest is go through that inventory. Many businesses have items piled up that aren't going to be used or sold. Get rid of these items. Sell them at a discount even if it's below the price you paid. If you can't do that, give them away. And if you can't do that, throw them away. There is no use in holding onto unsellable inventory.
The next step is to take a very close look at your current inventory practices. You want to optimize your inventory to demand. It also can be a good idea to reconsider carrying items that might have low demand, even if they are non-perishable items. It is best to focus on items that have strong demand and are easy to turn-over rather than spend resources on items that have a tendency to move slow. Managing inventory is complicated, and there are many things that need to be considered. Demand, optimum order quantities, storage costs, etc. It is one of the most challenging areas to master, so it is important to be constantly evaluating it.
Taking these three core concepts together will improve your balance sheet. Save. Reduce debt. Optimize inventory. If you focus on these key items, you will be well set to establish a solid foundation to grow a lean and effective business.