Master These 16 "Parts" Of Your Business To Maximize Revenue, Profit And Cash Flow

Leads are the number of potential ideal customers (i.e. prospects) that have been generated through your marketing efforts. This ‘part’ drives revenue because, generally, more leads will result in more paying customers. For example, if you have an HVAC business and you advertise online (e.g., Google or Facebook ads) for HVAC services, and a potential customer responds to your ad by filling out a lead capture form, you've generated a lead for your HVAC service. Lead generation is a function of optimizing your marketing, since marketing spend should drive the number of leads you generate.

This is the percentage of leads that become paying customers. Whereas leads measure your marketing effectiveness, conversion rate measures your sales effectiveness. This ‘part’ drives revenue because the more leads you can convert to customers, the greater the sales you can create from your marketing efforts. Let’s say that your HVAC business had 10 leads last week. If you were able to convert 2 of those 10 leads into a paying customer, then you produced a 20% conversion rate. (2 customers / 10 leads = 20% conversion rate.)

This is the percentage of customers who continue to buy your product or service (over a given time period, e.g. month/quarter/year) after the initial sale. This ‘part’ drives revenue because additional sales from existing customers increases revenue. Let’s say you had 1,000 customers who purchased prior to December 31st of last year. If you were able to get just 5% of those customers to come back and purchase this year, you would have 50 customers that already know, like and trust you that will spend money with you this year. Now, imagine that you were able to increase both Purchase Frequency Rate (explained below) and Retention Rate? You will see a major increase in revenue!

This is the number of times a customer purchases from you over a given period (e.g. month/quarter/year). This ‘part’ drives revenue because the more times you can get a customer to buy your product or service, the more revenue will increase. You can dramatically improve profit by getting existing customers to buy again. Not only will you be earning more from each customer (increasing their "lifetime customer value"), you'll also avoid having to spend additional marketing dollars to produce these sales (lowering your average customer acquisition cost). In other words, if the only thing you did to drive new sales was to get more existing customers to buy again, you'll increase your revenue without having to spend money on customer acquisition.

This is the average value of every sale. This ‘part’ drives revenue because the more you can get a customer to spend per transaction, the more revenue will increase (without having to generate more sales). Let’s say that in your HVAC business, the average value is $500. By improving the average transaction value to, say, $600, you will increase revenue by 20% ($600 - $500 = $100 / $500 = 20% increase) without having to make a single additional sale!

          Leads

x       Conversion Rate

=       New Customers That Buy This Period (e.g. Month/Quarter/Year)

           Existing Customers

x        Retention Rate

=        Existing Customers That Buy This Period

           New Customers That Purchase This Period

+        Existing Customers That Purchase This Period

=        Total Customers That Buy This Period

           Total Customers That Purchase This Period

x         Purchase Frequency Rate

=        Total Sales Transactions

           Total Sales Transactions

x         Average Transaction Value

=        Revenue

This is how much it costs you to provide the products or services for each sales transaction, and is measured as a percentage of revenue. The Cost of Goods should include all of the direct costs needed to deliver the end product or service to your customer. This ‘part’ drives profit because the lower you can get your Cost of Goods (as a percentage of revenue), the higher your gross profit will be. Using our HVAC business example, let’s say that you install a new air conditioning system in a customer’s home. Let’s also say that you charge your customer $1,000, but your material cost (from your supplier) is $600. Plus, you incurred $200 in direct labor from someone on your team to install the system in your customer’s home. This means your total direct cost of the installation is $800, resulting in Cost of Goods (as a percentage of revenue) of 80%. ($800 cost / $1,000 revenue = 80% Cost of Goods.) The goal, of course, is to get this percentage as low as possible.

This is the total cost of marketing measured as a percentage of revenue. This ‘part’ drives profit because every dollar you spend on marketing should have a direct correlation to an increase in revenue. If that happens, you’ll maintain a low Marketing Expense (as a percentage of revenue) relative to sales, thus improving net profit. If, for example, your total marketing expenses in your HVAC business last year totaled $20,000, and your total revenue last year was $100,000, then your total marketing expense (as a percentage of revenue) was 20% ($20,000 marketing expenses / $100,000 revenue = 20% Marketing Expense).

This is the total amount of payroll not already included in Cost of Goods. This ‘part’ drives profit because every dollar you spend on payroll should have a direct correlation to an increase in profit. In other words, every employee on your team should either assist in improving revenue or reducing expenses (or both), thus improving profit. Let’s say that in your HVAC business you have the following people on payroll: 

• Office Manager (@ $60,000 per year) 

• Customer Service/Order Taker (@ $40,000 per year) 

• One Master Technician (@ $90,000 per year) 

• Three Technicians (@ $60,000 per year each) 

Thus your total annual payroll is $250,000, plus related taxes and employer expenses (e.g., benefits), minus any direct labor that was already recorded in Cost of Goods (related to direct labor, in this case, your technicians). Let’s say that 80% of your technicians' payroll were already recorded in Cost of Goods. That means that only 20% of the One Master Technician and Three Technicians’ payroll should be included in Payroll Expenses.

This is all of the operating expenses that are incurred that are not already included in Cost of Goods, Marketing Expense and Payroll Expense. This ‘part’ drives profit because every expenditure in your business should provide a ‘return on investment’. If an expense does correlate to a return, then it shouldn't be incurred. Examples of typical operating expenses are rent, insurance, and office supplies.

This is the total of all income and expenses that your business incurs that are unrelated to your company's core business.  For example, cash received from an insurance payout, or interest income earned on an investment. Since these income streams are not unrelated to your company's core business, they would be recorded as “Other Income”.  An example of an “Other Expense” transaction could be the “writing off” of obsolete inventory.

          Revenue (using Parts 1-5)

x       Cost of Goods/Services

=       Gross Profit

           Gross Profit

-         Marketing Expense

-         Payroll Expense

-         Overhead Expenses

=        Net Profit from Operations

           Net Profit from Operations

+        Other Income

-         Other Expense

=        Net Profit

This is the number of days it takes to collect cash from customers. This ‘part’ is a key cash flow driver because the longer it takes for you to collect from customers (i.e. convert sales to cash), the longer you are without cash flow. Plus, during the period in which you're waiting to collect cash from customers, you're typically also incurring expenses (e.g., Cost of Goods) to service the customer, further constraining your available cash. Let’s say that in your HVAC company, you sold a $1,000 air conditioner on credit (for example, you agreed to let your customer pay for it in three months). Essentially, you are extending 90-day credit terms to your customer, and since it'll take you 90 days to collect, your Days Sales Outstanding is 90 days. Ideally, you want this number to be as low as possible (without sacrificing sales) so that you have access to the cash sooner. 

This is the number of days it takes for you to sell through your inventory, on average. This ‘part’ drives cash flow because the faster you sell your inventory (i.e. generate sales), that faster you can convert inventory to cash (i.e. when you collect sales).  Clearly, on the flip side, the longer it takes for you to sell through your inventory, the longer you are without cash flow. You purchased inventory with cash and, until you sell it, you are without cash. The cash is, figuratively, sitting on your shelves. If you purchased, let’s say, $10,000 worth of inventory to stock in hopes of selling to customers and it takes, on average, 120 days to sell through that inventory, then your Days Inventory Outstanding is 120 days. Ideally, you want this number to be as low as possible (without creating stock shortages and therefore losing sales) so that you have access to cash as quickly as you can.

An asset is something that your business owns that contains future economic value, such as a truck or a machine (used to operate the business and generate a return). When you sell it, you receive cash. Conversely, when you purchase an asset, it will decrease cash flow (unless you use debt to finance it). This ‘part’ drives positive cash flow (i.e. cash increases) when you sell an asset, and drives negative cash flow (i.e. cash decreases) when you buy an asset.

This is the number of days it takes for you to pay your suppliers. This ‘part’ drives cash flow because the longer it takes for you to pay suppliers, the more you get to hold on to your cash. Let’s say that it takes you 30 days to pay suppliers for a recent job. You could collect cash from your customer prior to having to pay your costs to service the customer. For example, if it takes you 20 days to get paid by your customer, and you pay your supplier in 30 days, then you have access to excess cash for 10 days that can be used in other ways. Ideally, you want this number to be as high as possible, without sacrificing good relations with your vendors. (Remember, your suppliers are your business partners, and they want to get paid in a timely manner as well. Not to mention, many suppliers provide discounts to their customers for paying early.)

Debt financing is when you borrow money to fund your business. This money, of course, must be paid back to the lender. Debt often comes in the form of bank loans, credit cards, selling ownership in your business (i.e. stock), or borrowing from friends or family, to name the most common sources. This ‘part’ drives positive cash flow (i.e. increases cash) when you originate debt, and drives negative cash flow (i.e. decreases cash) when you repay the debt. Debt can be used to improve the financial health of your business only if you’re using it to purchase something that will generate a return on investment (ROI). Before using debt, carefully assess if what you are planning to purchase with it will actually generate a return. For example, if you purchase a machine for $50,000, you should be confident that the machine will provide at least $50,001 in (present value) cash flow over the life of the machine. Of course, the higher the return the better.

Owner investments reflect cash that business owners invest, from personal funds, in the business. Owner Distributions, conversely, are cash disbursements to business owners who wish to take money out of the business for personal use (e.g. distribution of profits as personal income). The idea, of course, is that any investments that are invested by the owner(s) will provide a ‘return on investment’. This ‘part’ drives cash flow because investments are direct infusions of cash (i.e. cash increases), and distributions are direct outlays of cash (i.e. cash decreases). Of course, the main objective of a business is to provide a return for its owners in the form of ‘owner distributions’, ideally while still allowing the company to operate with healthy remaining cash flow.

                Profit (using Parts 1-10)

+ / -       Days Sales Outstanding*

+ / -       Days Inventory Outstanding*

+ / -       Sale or Purchase of Assets*

+ / -       Days Payables Outstanding*

+ / -       Using or Paying Down Debt*

+ / -       Owner Investments or Distributions*

=             Cash Flow

Not a numbers person?  Most business owners are amazing at what their business does, but not necessary great at numbers.  If you'd like my help implementing what you've learned on this page, go ahead and schedule a FREE 'Right-Fit" Zoom call with me.  We'll determine if we're a good fit to work together, and go from there!