I hear this all the time from entrepreneurs in my circle.
Things are going well. You have a product that costs you $5 a unit, and you sell it for $15 on average. You’re selling a lot of units-- let’s say 5,000 per month for a monthly gross profit of $50,000.
Let’s say you have rent & utilities of $3,000/month. 5 employees that cost you $20,000/month all-in. Legal, marketing, travel, supplies, and other general operating expenses of $5,000/month, on average. You’re still making $2,000 monthly payments on that credit card you used to start the business with.
Simple math tells you that you should be making $20,000 per month, but for some reason it’s stressful to take out $5k/month for yourself, and growing seems out of the question.
Where are my profits going?
This is part 4 of my How to Build Multi-Million Dollar Brands’ series. Find part 1 here: How to Build Multi-Million Dollar Brands -- Ask Me Anything!
I studied finance in college and it was a breeze for me because I loved it so much. My business partner is a CPA who graduated top of his class from the #7 accounting program.
Still, this was always a big question & point of confusion for us after finally getting a business off the ground.
Analyzing these situations in a classroom is one thing. Working through it when it’s your own money on the line and while you wear so many hats is another.
There are a few key elements at play. You don’t need to be an accountant or have in-depth, up-to-date, formal financial statements to understand & leverage them.
- Accrual Accounting vs Cash Accounting
- Free Cash Flow vs Net Profit
- Inventory Inflation / Inventory Turnover
- Practical Examples from my Business
Accrual Accounting vs Cash Accounting
For tax purposes, you generally get to choose what method of accounting you will use to calculate profit and pay taxes.
From the IRS:
Under the cash method, you generally report income in the tax year you receive it, and deduct expenses in the tax year in which you pay the expenses. Under the accrual method, you generally report income in the tax year you earn it, regardless of when payment is received.
Cash Accounting means you calculate profit by looking at what money came in during a period, minus what money went out. This is usually best for small businesses’ tax purposes, because you can realize the expense of inventory as you pay for it. So in the short-term, you can lower your cash accounting profit, and thus tax liability, assuming you are paying for goods on receipt (and not on terms – see part 2: [PART 2 - Net30 Terms] How to Build Multi-Million Dollar Brands )
When using Accrual Accounting, you realize an expense until the good purchased is sold, service is rendered, etc. So you’re matching up the date of COGS (cost of goods sold) for a particular good with the date you sold that particular good. This is how you’re thinking about profit in your head when you think to yourself “I know I am making a profit, but where is it?”
Accrual Accounting can be better for tax purposes if you are generally paying late on everything. ie. Paying for goods on terms, paying employees & contractors after services are performed, paying rent at the end of the month instead of the beginning, etc.
These concepts are, of course, more nuanced than I have explained here. But the important thing to understand is that if you know you’re making a profit but don’t see it, it’s because you are making an accrual profit, but not necessarily a cash profit.
Free Cash Flow vs Net Profit
Having a cash profit for a time period means you have Free Cash Flow that you can pay yourself with and invest in growth.
It is actually possible to have a cash profit but not an accrual profit. This happens if you are paying for goods some significant time period after receipt and selling + collecting payment for them before you pay for them, and paying for employees + services after gaining the benefit, BUT ultimately making no gross profit or small gross profit swallowed up by operating expenses. This is really the opposite of what this post is addressing and an unusual scenario for a small business owner in this space, but this is not good either.
Having an accrual profit means your sales minus COGS for those sales minus operating expenses in a period were over $0, AKA a Net Profit. Net Profit under $0 is also known as a Net Loss, or a negative Net Profit.
What we’re talking about in this post is having a positive accrual profit (Net Profit), but negative cash profit (Free Cash Flow). In this circumstance, it is tough to pay yourself, tough to pay down debt, tough to invest in growth, and tough to weather storms.
You want to optimize for free cash flow, not net profit.
The tricky part is re-optimizing your business to create Free Cash Flow without making your Net Profit negative, having to downsize staff, and / or failing to maintain enough inventory to fulfill orders, keep customers, and collect revenue.
Inventory Inflation / Inventory Turnover
The most frequent cause of negative Free Cash Flow + positive Net Profit that I see is Inventory Inflation, and as a consequence, slow Inventory Turnover.
Inventory Inflation simply means having more inventory than you need. Inventory Turnover is a metric that measures how fast you sell-through your average on-hand inventory levels (you want this to be low to produce Free Cash Flow & ROI).
Usually when people ask me why they don’t see the profit they know they make, I can identify the problem quickly by asking:
- How much inventory do you keep / have on-hand now vs some time ago?
- How much inventory do you have on-hand vs how much you sell every 2 weeks?
Most owners’ profit is found in higher than previous, higher than necessary inventory levels.
It’s important to track & manage inventory like a hawk.
- Figure out how much finished product (ready-to-sell) inventory you need to keep on-hand. In most cases, this should equal 2 weeks of sales on a sku-by-sku basis.
- Figure out how much raw material inventory you need to keep to meet production schedules that ensure you maintain 2 weeks of finished goods inventory on-hand. I like to keep 1 week, when possible.
- Consider what constraints will make hitting these metrics difficult or impossible.
Sometimes it’s just not possible to meet these numbers. Here are a few reasons why…
Sales volume is volatile, so maintaining 2 weeks of finished goods inventory will cause you to be out of stock frequently when sales spike.
SOLUTION(S):
(a) Maintain a larger finished goods inventory that can handle those spikes.
(b) Find a way to smooth out sales volume into something more consistent & steady. ie. Ask customers to buy less but more frequently, and honor the same bulk price – price on monthly purchase volume rather than single-purchase volume. Pro-Tip: If you can get them to agree to pay full-price in the short term, then credit back at the end of a month or quarter based on the volume they purchased, this is ideal.
Your supplier(s) won’t give you prices you can make money on if you don’t buy enough at once.
SOLUTION(S):
(a) Ask supplier(s) to let you buy less but more frequently, and honor the same bulk price – price on monthly purchase volume rather than single-purchase volume. Pro-Tip: Unlike above for customers, you don’t want credits back but instead the same bulk price on every small purchase.
(b) Ask the supplier for better payment terms – best case, you pay for product 30, 60, or even 90 days after receiving it.
(c) Secure financing. It’s tough in this business, particularly if you have poor personal credit / no collateral. In that case, focus on solution #2. Otherwise, even a credit card with a high interest rate isn’t a bad idea if you are cautious, and you can usually get 0% APR for the first XX months.
Lead times are too long.
SOLUTION(S):
(a) Order smaller and with greater frequency if you can get the same price to smooth out your COGS over the long-run.
(b) Find a supplier with lower lead times, even if it means paying a higher but still work-able price. This is more ideal, because long lead times don’t just force you to hold too much inventory-- they also make it tough to keep up with growing demand.
The above issues and solutions assume you are already cautious with inventory and manage it better than average.
Too often, I see people making these beginner mistakes…
- Buying large amounts of inventory just so they don’t have to bother with ordering often. Order weekly, if you can. Don’t be lazy.
- Always optimizing procurement for the lowest possible price, and largely ignoring lead times + appropriate stock levels. Depending on your gross margins, and price differences, it is often better to pay more more to get lower lead times and lower purchase quantities.
Practical Examples from my Business
When it comes to procuring labels & boxes, unit prices fall sharply with volume. If you can, you generally want to buy at the volume where volume discounts drop to a negligible level.
It is proper to buy more when volume discounts are so substantial that the benefit to ROI of these discounts to overall profitability is greater than the benefit of turning over inventory faster.
Because there is so much up-front expense for a print company to make product for you, unit prices can be $10 per box in low quantities like 1,000. Get to 10,000 and the price is now $1.25/piece. 20,000 and it’s $.70/piece.
Practically the same total cost no matter how many you buy.
But then maybe you get to 40,000 and the price is $.60 per piece. That’s a much lower % discount-- you should buy 20,000. We call this diminishing marginal utility / return.
We now buy 3 to 4 months worth of boxes & labels, and pay 90 days after receipt (negotiated with supplier). So everything is mostly sold / used before we pay. Even though our inventories are bloated, it doesn’t harm our free cash flow.
If we could grow 3x so that buying 1 month of inventory got us the same price, we would buy every month, still with 90-day payment terms. We would effectively be borrowing the total cost of each order for 2 months at an effective interest expense equal to the unit savings we would realize if we still purchased 90 days worth of stock multiplied by the order quantity of 1 month’s worth of stock. That interest rate is exceeded by our business’ ROI.
Jars from China
The price we pay for jars ordering direct from China is ~60% lower than if we buy domestically with 1 week lead times. Contrary to my advice in this post, we still buy from China – paying cash up-front with 3 month lead times – because the savings are so significant. To buy domestic would be an effective ~600% APR. Our ROI does not exceed that interest rate.
Wrapping Up
Manage inventory carefully. Cost of inventory on-hand is usually the biggest component of the denominator when calculating ROI, and it’s the usual suspect when diagnosing low or negative free cash flow.
Thoughts? I’m curious as to how much practical sense this makes for everyone. If it’s digestible and you guys want to go deeper, I can share (a) how to calculate ROI and use it to decide whether to accept higher lead times & cash-up-front terms in exchange for discounts & vice versa, (b) potential financing options and their impact on free cash flow + net profit, and (c) models for executing on the guidance in this post.
As always, questions welcome. Please ask in the thread if you don’t mind so others can learn, too.
Curious to hear how you think about this topic.
