” Revenue is vanity, Profit is sanity… Cash is King”
Every business owner should have this etched in their brain. Or maybe tattooed on their arms or something. Whatever works for you to be constantly reminded of this phrase.
I don’t know who said this quote first but it is profound. And I’ll tell you why:
When you start out in business you set goals – some goals are Big, they are Hairy and they are Audacious. And some of those goals will be related around money (see: Business is about money). But let’s be very clear about the goals you set and the type of money you talk about.
Revenue is NOT money
Let’s start with “revenue is vanity’: Revenue is the amount you charge for the products and services that you offer. For example: if your client signs a contract for your consulting services for $15,000 this is considered your revenue (income).
HOWEVER… things may happen and during the cause of the consulting assignment you may agree to give your client a discount. This discount is entered in your books as Cost of Sales. It is seen as a necessary expense in order to complete the sale. So while your revenue (income) on paper is still exactly the same, the ultimate payment on the invoice (the cash that you’ll get in your bank account) will be the invoice amount minus the discount given.
This little example shows how easy it is to inflate your company’s revenue – by invoicing the Recommended or listed price before discounts for example – so next time when somebody proudly proclaims that their business has gone from $0 to $2M in revenue in 10 months flat, you might want to follow up with some questions about their profits and cash flow… 😉 Revenue is vanity, right?!
Examples of cost of Sales items
Cost of Goods – These are the necessary items you need to do or purchase in order to make the sale. If you don’t do this you can’t sell what it is that you’re selling.
Examples of what we have listed in our cost of sales are:
- Stock (for horses-store as this business has physical stock on hand)
- Accreditation Fees (for The Art of Service as we are not allowed to sell our ITIL courses without the proper accreditation)
- Merchant facilities fees (as we run online businesses, we can’t sell unless we have a merchant facility attached)
- Discounts given
Another example is in Real Estate. For example when you flip houses, you purchase a property and sell it quickly.
The sale amount of the house (let’s say $490,000) will be seen as your income/revenue. However, you can only sell the house when you have it on your books, so the cost of sale is the cost of purchase of the house ($390,000).
The gross profit (revenue – Cost of Goods Sold) = $100,000
Profit is Sanity
The next step from income and gross profit is to identify the cost involved in the running of the business (operational cost / expenses). In the example of the real estate business before, you have $100,000 to play with. That is the money you can spend on fixing up the place, advertising and marketing expenses, GST, Accounting fees, the lease of your office and car, your personal income/takings etc. etc.
Gross profit – Expenses = Net Profit
The net profit is the true profit of your company before you’ve used that money to pay income tax.
Do you see now why revenue is vanity, but profit is sanity? When you know the profit levels in your business (both gross profit and net profit) you can make educated decisions.
And you can work backwards. You know roughly what your fixed costs are:
- Office rent
- Staff expenses (wages + super annuation + PAYGW taxes)
- Monthly Subscriptions (internet, phone, software)
You add this up and you get to $80,000. Your goal is to have a minimum of 5% net profit so you know that you will need to end up with $84,000 as an absolute bare bottom minimum of Gross Profit.
Now that you know your minimum gross profit you can add in the cost of goods sold. In the example of the real estate this was $390,000. Which means that the minimum sales price must be $390,000 + $84,000 = $474,000 (assuming there are no further cost of goods to take into account).
Once you know this, you will have a much stronger negotiation position because you know how flexible you are on the sales price.
NOTE – this example isn’t complete as it doesn’t take into account the variable expenses. Don’t forget about them.
Cash is King
Why is cash so important? Because without cash you can’t pay your bills. Without cash you can’t repay your credit card debts, loans and tax payments when they fall due.
In the example of the real estate, the full amount of the sale was $490,000 so we can assume that this included 10% GST ($44,546) which will need to be paid to the Taxation Office (part of the variable operational expenses)
If you didn’t cater for this and you don’t have the cash in the bank account to pay for this, you’re in trouble.
Yes – I know you can claim back the GST you’ve paid on your purchases so the final tax bill will be a lot less. This doesn’t take away the message that you need to look at your cash flow to understand if you’re in trouble or in luck.
There are many business owners who boast about their 6- or 7 figure businesses, but when you ask further they’re not making any money. There is no cash in the account, or at least not enough.
Many of these business owners have trouble sleeping and have high levels of stress and anxiety. Please don’t be one of them!…
Long live the king!
PS – I am not an accountant.. I am an entrepreneur and business owner who has made it my job to understand the numbers of my business. I wrote this blog to make you think about the numbers in your business. Please check with your book keeper or accountant how my ideas apply to your business.