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Are you making an investment
or are you buying yourself a job?
Currently, much of the corporate business world is busy responding to the demands of their stockholders and boards of directors. The concern they are attempting to address is how to respond to the challenges of today’s business environment.
Of course, as a small business owner you must also address the challenges of today’s business environment. Fortunately, you do not have directors and stockholders to please. However, while those in the corporate business world could lose their job with a failed business, as a small business owner you not could lose your job, you could lose the investment you have made in your business.
The investment. This is the unique aspect of owning your business. As the active owner in your business you receive a paycheck, but that money is for the work that you do each week. It is very similar to the paycheck that you give to each of your employees. The investment is the part of owning a business that is often forgotten.
When you first started your business, there was the initial outlay of cash for equipment, inventory, and the operating expenses you would incur before you made your first sale. Even as a business moves through the first months, there is often more of a cash outflow than there is an inflow. It is this same investment that is utilized to keep the business afloat until it becomes profitable.
In some situations additional investment is required as the business grows in physical size and or sales volume. Sometimes the owner of the business goes to a bank or outside individual to garner these additional funds. When this happens a contract is created which specifies how the funds are repaid. One of the components of that contract is the interest rate charged by the lender.
While we find that most every business owner will pay attention to knowing what that interest rate is that they are paying to a lending institution or other individual, we also find that many do not ever think about the interest that their business should be repaying them on their investment.
While many do not set up a formal contract between themselves and the business, it is only right that you should expect the business to pay interest on the money you have invested. Perhaps the comment made about small business owners that ‘they have bought themselves a job’ comes from situations such as this.
Once you have decided that your business should be paying interest to you for the investment you have made, there are two important questions that need to be answered. The first question is, ‘how much interest is the business currently paying you?’ and the second question would be, ‘how can I get my business to pay me more interest on the investment I have made?’. On the way to answering these two questions, we will also learn how the math works behind this calculation.
In the investment world, the interest rate paid to you increases as the risk factor increases. In your business, you can make the risk factor decrease by doing a better job of understanding how your financial statements are created and the factors that go into creating them.
To answer these questions we need to gather some information from your profit and loss statement and your balance sheet. Follow these steps and we will not only determine how well your business investment is paying you, but how you can make it better.
We begin by looking at your year end profit and loss statement and balance sheet. Sales need to be broken into two groups; the first being cash and credit card sales and the second being the corporate charge accounts that you may have. In addition to the information we see there, we need to do a couple of calculations based upon the balance sheets from each of the twelve months.
We need to calculate the average inventory on hand for the year. To determine that, you add the ‘inventory on hand’ from each of the year’s twelve balance sheets. Then, divide that total number by twelve. The resulting answer is your average inventory.
We also need to determine your average accounts receivable. Again from each of the twelve balance sheets of last year, we collect the accounts receivable amount and divide by twelve.
And from your balance sheet, we need your year end total of long term assets and the total of the current assets other than the inventory and accounts receivable that we already mentioned.
Looking at the year end profit and loss statement, we can determine your gross margin, operating expenses as a percentage and your net profit percentage. With the breakdown in sales we can also determine the percentage of sales that are on credit. Comparing the amount of sales annually to the average accounts receivable, we can quickly determine how well the business is collecting the monthly receivables. Mathematically, you take the average receivables and multiply them by 365. You divide that answer by your annual charge account sales. The answer is expressed as a number of days. As a general guideline, you should collect your receivables in 1.5 times your credit terms. If your terms are net 30, you should have an answer of 45 or less.
By not collecting your receivables promptly, you are in effect loaning money interest free and greatly reducing the return on your investment.
The second aspect of your investment that we can determine is your inventory turn. As you purchase inventory for your business, you have to determine the quantity to be ordered based upon several factors; how quick you will sell the merchandise, how much room you have to store it, the price of the merchandise, and how soon you have to pay for it.
Increasing your inventory turn is a sure way to improve the investment in your business; just so that you are not increasing it while at the same time you are losing sales because you don’t have something in stock. To calculate your inventory turn rate, divide your year end cost of goods sold by the average inventory on hand. The resulting number represents the number of times you sell your inventory within a year.
The third observation we can make about your business will be as we calculate the return on assets. This measurement indicates that of all the assets your business has, whether or not they have been paid for, how well you are leveraging them to make a profit.
To make this calculation, you divide the annual net profit of your business by the total, both current and long term assets. The resulting answer is stated as a percentage and indicates how well the assets of the business are being utilized to make a profit.
To maximize the return on assets, you will want to examine what the investments in your business are doing for you. Do you have equipment that has sat there for the last couple of years? If so, your getting this equipment turned into cash will go a long way to increasing the return on your investment.
Looking again at the year end profit and loss statement, you need the net profit. Divide the net profit by the net worth of the business. The net worth is on the balance sheet, but may appear in one of several forms. It may have the title of ‘net worth’, ‘equity’, or ‘stockholder’s equity’.
The answer you receive is stated as a percentage and represents the rate of return the money you have invested in your business is paying you. There is not a right or wrong answer that we can give you. Instead, the number has to be one that you are comfortable with.
You need to examine the rate of pay you are receiving from your business, the benefits you receive from the business, and the amount of time as well as degree of difficulty at which you work. When you consider these factors, are you pleased with the results? Is the result one such that your money could not earn elsewhere for you?
It is just like your making an investment in a stock, bond, treasury note, or other investment. Are you pleased with the rate of return and do you feel secure that this is the best possible place for your money to be invested?
If so congratulations! And by knowing how well your money is working for you, and how that calculation is made, you can perform the necessary tasks to improve your business and the investment you are making.
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This article is copyrighted by Tom Shay and Profits Plus Solutions, who can be reached at: PO Box 1577, St. Petersburg, Fl. 33731. Phone 727-464-2182. It may be printed for an individual to read, but not duplicated or distributed without expressed written consent of the copyright owner.
Profits Plus Solutions, Inc.