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June 2015

How Strong and Safe is Your Company? Answer: Net Equity

How Strong and Safe is Your Company? Answer: Net Equity

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Net equity is the second of our “Triple Bottom Lines, and tells the business owner how strong and safe their company is.  Perhaps more importantly, when compared over time, it indicates whether their business is getting stronger and safer or weaker and closer to going out of business.

For most people, net equity sounds like a foreign language, but many of us can relate to this figure if we compare it to the equity we have in our own homes. For instance, if I own a house that’s valued at $500,000 and my loan amount is $300,000, then the equity I have in it is $200,000. If I pay down my loan to $250,000, I’ve increased the equity by $50,000. Doing so lowers the chance that my home will be repossessed, and shows increasing strength and safety for me as the owner.

The net equity of a business is really no different. Like home equity, the figure represents the assets minus the liabilities.   If a business’ total assets, such as cash, inventory, equipment, owned property and such equals $750,000 and its liabilities that include payables, debt, employee accrued vacation time and such totals $300,000, than the company’s net equity is $450,000.

So, in a business how do you control net equity?  It’s really simple. Either you increase assets or decrease liabilities.  Every month that a business makes a profit and retains that hard earned cash in the business, it is increasing net equity, because that business now has more cash and assets than it did the month before.

When studying net equity, I like a simple green arrow up (if net equity increased) or a red arrow down (if net equity decreased).  For most business owners, this is all you need to know, because, if you are getting stronger and safer (green arrow up) that is a good thing; however, if your net equity is decreasing (red arrow down), then you need to look into why net equity decreased and reverse that trend quickly.

 

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Traditional Forecasting leads to Traditional Results...Failure

Traditional Forecasting leads to Traditional Results…Failure

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Every business starts out with optimistic spreadsheet projections of profit and success.  Unfortunately, according to a 2012 University of Tennessee study, more than half of these businesses will fail within the first four years of operation. Of those failed businesses, 72 percent say they went out of business because they ran out of cash.  Tragically, 77 percent were started with the owner’s life savings.

Worse, many of these businesses failed after hitting — yes, you read that correctly – hitting or in some cases exceeding their forecasted sales projections.

So, why do “successful” businesses fail?

I met a woman last week who started her business four years ago.  We will call it “Brand A Products.” She is the epitome of sales success; having grown revenues by more than 100 percent per year, and, in 2012, she topped the $1 million mark in sales. She is on track to double revenues again this year, but is still not making money. Worse yet, she doesn’t know why and is running out of cash. To save her business she was looking to sell 30 percent of her Company to investors and raise $450,000.  Without the cash, the business will close in three months

Brand A forecasted profits using the standard spreadsheet. She blew away her sales projections. Unfortunately, she forecasted profits based on sales and spending – meaning when she would spend cash, and when she would make sales – instead of the standard accounting format known as “accrual.” In doing so, she fooled herself into believing that sales are all that matters, that sales equal cash and that payments and deposits equal income.

Unfortunately, none of this is true.

Brand A can make a sale, receive a pre-payment or deposit and all she has done is created a liability (a future obligation for work/product). Once Brand A receives this payment, she still has to go out and do the work, which is a liability, without any future cash payment from the customer, because she already got paid.

What if Brand A used that client deposit to make payroll this month? Unless, she receives another larger deposit next month, or, more importantly, makes a profit on the sale, she might be out of business next month.

Forecasting income based on proper accounting standards is important if you want your business model to run smoothly. That’s because an “accrual” income statement aligns revenues with their related expenses for each month. In doing so, companies can quickly see if they have efficient overhead, are pricing their products and services correctly, and have a sustainable gross profit margin. However, forecasting a profitable accrual-based income statement is not enough.  An accrual-based income statement won’t tell you when your company will actually see cash.

Take the example of a law firm. Lawyers often perform legal work and may not see payment for 30 to 90 days, while employee salaries, benefit costs, rent and other expenses must be paid before collection. If your firm doesn’t have available cash to cover these costs, you’re in trouble.

Cash is king.  You can’t pay bills with promises…at least not forever.  You must put real dollars in the bank. However, very few small businesses bother to forecast a cash flow statement. Without it, you are flying blind. That means, like Brand A, you could be increasing sales while simultaneously running out of cash and going out of business.

A properly forecasted accrual-based income statement provides vital data on how a company is operating. Entrepreneurs must use this data to achieve real meaningful profits. Cash will eventually follow profits, but a profitable business can still run out of money by not collecting, paying too early, or just growing too fast. Even if your business has strong sales and a great vision, you can force it out of business by not forecasting and maintaining cash.

Thankfully, Brand A was able to make some changes in time.  After forecasting a true accrual based income statement and cash flow, the company’s owner has the visibility to cut a few unnecessary expenses. She has renegotiated terms with a few of her suppliers and, without giving up 30 percent of the business, will have enough cash to survive and thrive. It’s a success story that can be a model for other business owners to follow.

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