Many entrepreneurs struggle to understand and manage their finances. Greg Crabtree is a Certified Public Accountant (CPA) who has worked with banks, financial institutions, and financial data from hundreds of businesses. In this book, he simplifies business finance to help you make sense of financial numbers, make smart business decisions, and grow a truly profitable business. The insights are targeted at small businesses (from startups to $5mil revenue), but are still applicable for larger businesses with >$5mil revenue. In free version of the summary of Simple Numbers, Straight Talk, Big Profits: 4 Keys to Unlock Your Business Potential, you’ll learn about the 4 keys to business profits and how to build them into your business.
Do also check out our complete summary bundle in pdf/mp3 infographic, text and audio formats!
Part 1. Mastering the 4 Keys to Profitability
There are 4 issues that prevent small businesses from building the right financial foundation: owners’ salary, profit, labor efficiency and cash flow. These problems multiply as the business grows. If you’re not profitable when the business is small, you won’t become profitable when the business is big.
1. OWNERS’ SALARY: Go for Market-Based Wages
Many entrepreneurs confuse owners’ salary vs profits. A salary is what you earn for working in the business, and a profit is a reward for your business ownership. A truly profitable business should be able to (i) pay its owners market-based wages (assuming they’re working full-time in the business) and (ii) provide a good return on their equity (or what they own). Otherwise, the business isn’t profitable enough.
In reality, 90% of entrepreneurs underpay themselves either because the business isn’t earning enough, or because they’re trying to save on taxes. Entrepreneurs may pay themselves below-market wages to reduce taxes, then take profit distributions or even use company funds to pay personal expenses (e.g. groceries or house repairs).
This distorts the business’s financial picture. For example, a company may pay its owner $20,000 (instead of $100,000 of market wages) and declare a 5% profit. In reality, it’ll make a loss if the full salary is included.
If you do this in an S-corporation, it could also attract an audit by the Internal Revenue Service (IRS). Incomes from S-corporations are treated as the owners’ personal income, and taxed at an individual (not corporate) level. So, the IRS treats distributions as salaries especially if they’re taken on a regular basis.
If you’re a business owner, pay yourself a market-based salary. As yourself: if you passed away today, how much will your successors have to pay to get someone else do your job? You can use websites like erieri.com or salary.com to research the salary ranges.
If the business can’t afford to pay you a market-based salary yet, then keep track of the wages you’re giving up: this is your “sweat equity.” Let’s say your market-based wage should be $75,000, but you pay yourself nothing in Year 1, $50,000 in Year 2, and $75,000 in Year 3. This means that you’ve invested $100,000 of sweat equity over 3 years.
In short, your first goal is to grow the business until it can pay you a market-based salary and still be profitable. Make sure you can live off your market-based wages instead of relying on profit distributions. If your profit numbers don’t reflect your business realities, rectify it asap because you’ll need accurate financial numbers to set meaningful goals and make informed decisions.
In our full 15-page book summary, we’ll also explain:
• How to use sweat equity to ensure fair compensation in a multi-owner company;
• How paying market wages will make it easier for the owners to eventually exit the business; and
• Why you should also pay all your employees a market-based wage.
2. PROFITS: Aim for 10-15% Pretax Profits
A business that’s not profitable simply isn’t sustainable. Specifically, small businesses should focus on gross profits and pretax profits, instead of figures like EBITDA or revenue.
It’s also not enough just to breakeven, i.e. to have income = expenses. You should aim for pretax profits of 10%-15% of revenue.
• Pretax profits of ≤ 5% revenue = business on the brink of death
• Pretax profits of ≥ 10% revenue = a good business
• Pretax profits of ≥ 15% revenue = a great business
Do get our complete version of the Simple Numbers, Straight Talk, Big Profits summary (click here for the full book summary) for:
• An explanation (with sample calculations) of key financial terms like COGS, Gross Profit and Pretax Profits; and
• Why most companies enter a “Black Hole” when they reach $1mil-$5mil revenue, and what you must do to survive that crucial period of growth.
3. LABOR PRODUCTIVITY: Maximize Gross Profit per Labor Dollar
Every business needs people to function. Hence, a key profit lever is labor productivity, or the gross profit per labor dollar. For example, you can aim to create $2 gross profit for every $1 invested in labor.
Remember: growth is not the solution to profitability; labor productivity is. This factor also directly affects your ability to survive the Black Hole.
In our full Simple Numbers Straight Talk Big Profits summary, you can dive into details on labor productivity including:
• How to calculate and manage your salary cap (i.e. the maximum you should spend on labor) while staying within the target pretax profits goal of 10-15%;
• Specific ways to improve labor productivity; and
• Dos and don’ts for incentive programs.
4. Business Physics: Master the 4 Components of Cash Flow
To master this key, you must (i) learn the difference between revenue, profit vs cash flow and (ii) know where your cash is going. Otherwise, you may sell $1mil worth of products yet end up with no cash at the end of the year.
Use your cash wisely in this sequence: Pay your taxes => Repay your debts => Reach your core capital target => Take profit distributions. Crabtree calls these the “4 forces of cash flow”. Do get our full 15-page summary to for specific tips and insights for each of these 4 cash flow drivers, including:
• Why/how to set aside money to pay your taxes;
• Why you should get rid of existing debt asap. Learn the differences between term loan vs line of credit, debt vs capital, and the 3 sources of capital to consider if the business needs extra funds;
• How to meet your core capital target, i.e. set aside 2 months of operating expenses in cash without drawing on a line of credit; and
• Why you should only take profit distributions only if the above items are addressed, and the money isn’t needn’t to strengthen your business.
Part 2. Managing Financial Data
Besides understanding the keys to profitability, you’ll also need accurate numbers to sense the pulse of your business and make sound decisions. In this section, we’ll cover (i) cash-based vs accrucal-based accounting system, (ii) using forecasts instead of budgets, (iii) how to create a reporting rhythm so you have the right data at the right time, and (iv) know how to calculate your business’s economic value (so you know the right price to the business or how much shares to offer employees/partners).
More from “Simple Numbers, Straight Talk, Big Profits”
If you’d like to learn more about each of the 4 keys to profitability and start making smart financial decisions, do check out the our full book summary bundle which includes an infographic, 15-page text summary, and a 29-minute audio summary.
This book is written in a casual, conversational tone with various examples from the authors’ clients, as well as sample spreadsheets and financial numbers. You can purchase the book here or visit simplenumberscri.com for more information.
To learn more about building a profitable business, do check out our Profit First summary. Or, learn how to read financial statements and know what the numbers really mean with the Financial Intelligence summary.
Strengthen your business foundation with 4 keys to profitability!