By Richard Tyson
With PPP and EIDL money, many small-to-medium-sized businesses have breathed a little easier during the pandemic. However, such cash infusions — if you are not careful — can distract you from staying vigilant in managing your company finances. Even though your working capital needs have diminished by virtue of these stimulus monies, you must not overlook the fundamental elements of sound financial management.
Let’s begin with your income statement, or P&L. What story does this document tell you?
A few years ago, one of my clients announced that he was in the process of retaining a bankruptcy attorney. The trends in his P&L showed a consistent pattern of declining gross profit, and no net profit for several years. He said that it was time to “throw in the towel.”
This business owner had always resisted sharing his financial statements with me, and now it was clear why. He was embarrassed. It took his sense of impending disaster to get him to put his P&L on the table. At this point, when he was sure it was too late to help him, he shared his numbers.
His business was, indeed, in severe financial straits. He told me that in a recent conversation, his banker had informed him that if he didn’t come up with an acceptable plan to reverse things, they would have no choice but to call due both his long-term loan and line of credit.
It was at this point that I suggested that we “peel the P&L onion.” What I meant was that while the income statement tells a story, in and of itself, it is generally insufficient to provide any sense of what to do to improve things. We needed to dig deeper. I assured him that each layer of his financial onion that we peeled back would get us closer to the root causes of his problems. With those in hand, we could work toward solutions.
The consolidation of numbers on his P&L needed to be dissected. I asked my client to show me a list of all of his customers with their respective revenue, cost of goods sold and gross profit for the last year. With this information in hand, we were able to calculate the gross margin (gross profit as a percentage of revenue) for each customer. We then rank-ordered them from the highest gross margin to the lowest.
This information gave us some very interesting insights. The highest gross margin customers were actually my client’s largest (highest revenue) customers. However, as a percentage of his overall revenue, these high-margin customers were steadily declining, while his smaller, lower-margin customers were growing as a percentage of overall revenue.
Of course, the question here was “Why?” My client squirmed a bit at this point. “Well,” he said, “these smaller customers are old friends. I give them a sweetheart deal because of our friendship.”
Further questioning (onion-peeling, if you will) led to the discovery that these friends not only received preferential pricing, but their projects were also always given priority in the production queue over the larger, more profitable ones. Because of this, the better projects were migrating away, often to the competition.
So, what to do? A tough decision had to be made. If the business was to be rescued, they would need to put a laser focus on the larger, high-margin projects, including freeing up operating capacity for those jobs by phasing out the “friend business.”
This conclusion was very hard for my client. He had to go to each of his friends, explain the situation and gently fire them. Tough medicine, to be sure, but essential for the survival of the business.
With clarity regarding the new strategy, my client formed a plan that proved to be acceptable to his bank. They stressed that they would keep a close eye on his progress, but they agreed that he had identified the problem and had a solid plan for solving it. A year later, my client announced that he had achieved his highest profitability in 30 years.
Peeling the onion generally means something different for every business. However, it’s a leadership exercise that every CEO and/or business owner should do. Start with dissecting your P&L and go from there.
Richard Tyson is the founder, principal owner and president of CEObuilder, which provides forums for consulting and coaching to executives in small businesses.