Knowing your numbers
If you’ve ever watched Dragon’s Den or Shark tank you’ve seen countless budding entrepreneurs squirm, and then leave empty handed because they didn’t “know their numbers”. It always goes the same way – the dragon or shark asks for a number, which the entrepreneur usually nervously provides. It is then pointed out how the number doesn’t tally with the rest of the entrepreneur’s story. There is an awkward silence followed by a request for another ”number”. But by now the budding entrepreneurs mind has gone blank. There is no coming back from this. As the dejected reject trudges out one dragon or shark turns to the other and says “you’ve go to know your numbers”.
"...But what are these “numbers”? What numbers are they talking about, why do you have to know them, and how do you find them out?..."
By numbers what we mean is financial metrics that are measures of a business’s performance. And the number of them is endless. Below we’ll take you through the most important ones. If you have a business and don’t know these numbers, don’t go on Dragons Den or Shark Tank.
Income statement - the Basics
The first number the inquisitors on the telly always ask for is turnover. Also commonly referred to as revenue, this is very simply how much money came into the business. If you are a trading company it would be your total sales. If you’re a service company it’s your total fees. Essentially it is how much money did people pay you for the goods or services you provide. This is very fundamental to any profit driven enterprise. If you want to make money, you’ve got to get someone to pay you.
Gross Margin / Gross Profit
If the sharks or dragons think you turnover is acceptable they’ll ask you about your gross margin, also known as your gross profit. To understand these you really need to understand the concepts of cost of goods or sold direct costs. Let’s go through these first, then we can come back to Gross Margin.
Cost of Goods Sold
This one really does do what it says on the tin. It is quite literally the cost to you of the goods that you have sold. If you are a trading company it is very simply the cost you paid to buy the stock that you subsequently sold. The only trap here is you need to remember that it does not include stock that you have bought but not yet sold. If it is still sat in a warehouse somewhere, or your mum and dads garage, it is not yet a cost.
If your business is in manufacturing or production the concept of cost of goods sold is exactly the same, it is the amount that it cost you to produce what you sold. It is far more complicated to calculate than if you just bought what you sold, but that’s another story for another day.
Direct Costs are just cost of goods sold but for a service business. Ie, how much it cost you to provide the service that your customers paid you for.
Costs of goods sold and direct costs are also known as Variable Costs
. This is because they vary depending on how much you sell, or what your turnover is. In order to be able to sell more stock you’ll have to buy or produce more stock, so your variable costs will go up. Similarly if you’re a traditional service business, like say a plumber, in order to fix more toilets you’ll need to employ more people, and so your direct or variable costs will go up. There are exceptions to these rules, especially with modern digital products and services, but let’s try to keep things simple.
"...If you’ve got a shop or a restaurant it doesn’t matter if you have one customer or 100, you’ve still got to pay the same rent..."
Fixed Costs, you may have guessed, are the opposite of variable costs. They don’t change depending on your level of sales or fees. The obvious example of a fixed cost for traditional bricks and mortar businesses is the business premises. If you’ve got a shop or a restaurant it doesn’t matter if you have one customer or 100, you’ve still got to pay the same rent.
As promised, this brings us back to Gross Margin
Gross Margin is how much you sell one product or service for minus the direct or variable cost of providing that product or service. It is often expresses as a percentage. So if it costs you £100 to manufacture or buy a product and you sell it for £400 your Gross Margin is £300 or 75%.
Similar to Gross Margin is Gross Profit
. This is total turnover minus total cost of goods sold/direct costs/variable costs. In other words it is the total gross margin on all of your sales added together.
"...You might think it sounds great to have sales of a million pounds however if your gross margin is too low you won't make any money...."
Gross Margin is key to a business because if gross margin is too low then increasing your sales will not significantly increase how much money you make. You might think it sounds great to have sales of a million pounds however if you sell a product for £1000 but it costs you £999 to produce your million pounds of turnover will only give you a Gross Profit of £1,000. This is why its always the second number the dragon asks for. Because high sales are meaningless if your gross margin is too low.
Net Profit rounds out the basic profit and loss report (now called income statement). Net profit is Gross Profit minus fixed costs and also minus tax. Or to put it another way it is turnover minus all costs. Of course if those costs are more than your turnover you won’t have a net profit at all, you’ll have a loss.
Income Statement is the primary financial report that shows all of the numbers mentioned above. If you want to be an entrepreneur it is vital to understand these terms as this is the basic jargon which business people use to describe the levers you can pull to steer your business. If you don’t understand the relationship between these numbers you will struggle to effectively manage your business.
For example you need a high enough gross profit to more than cover your fixed costs so that you have a net profit. If your gross margin is too low then your gross profit is unlikely to cover your fixed costs, which means you will make a loss. In this situation increasing sales will not necessarily help, so what do you do? You have two options. You can either increase your sales price or you can find a way to cut your variable costs. Both of these will increase your gross margin, but it is up to you as the entrepreneur to decide which one is right for your business. If you are in an industry with price sensitive customers then increasing you price may lead to lower sales and be counterproductive. On the other hand, if your customers value quality then trying to cut production costs could be a risky strategy if it results in a drop in quality.
Income statement - slightly more advanced
On the advanced course you may here people mention EBT, EBIT, EBITDA
or even EBITDAM
. In all of these the E, B and T stand for Earnings Before Tax. The I is Interest, the D is depreciation, the a is amortization and the M is management fees.
You may not hear the dragons or sharks mention these terms on the telly because it would be too confusing for too many people at home. However these are all common concepts when you are trying to value a business to sell it, or to get someone like a private equity house to invest in it. And to be honest, that is a scenario you are more likely to find yourself in.
The point of excluding tax, or interest and tax, or interest, tax, depreciation, amortization and even management fees from earnings is that you are trying to understand how the actual underlying business performs. This is because that is what the investor is investing in.
"...excluding these costs from the measure of business earnings given an investor a better understanding of the performance of the underlying business..."
Interest is the cost of financing the business, it is not a cost of running it, so it is commonly excluded. Similarly management fees are often a way that the owner of a business extracts profits from a business, so they distort the picture of how well the business is actually doing. Finally depreciation and amortization are ways of spreading out the cost of setting up the business and of buying the equipment and machinery that the business needs to operate. So these are costs that have already been spent and will not necessarily need to be spent again.
By excluding these costs from the measure of business earnings an investor gets a better understanding of what the on-going performance of the underlying business is likely to be.
Balance Sheet - the Basics
All of the above terms relate to the performance of the business, ie how well the business is doing. They can be found on, or derived from numbers on the income statement. The income statement shows how well the business has done over the previous year. However in order to get a full picture of the financial health of a business you also need to know the financial position of the business. This is what the balance sheet is for. It tells you what the company owns, who owes it money and who it owes money to.
In short, a company’s assets are everything that it owns that is likely to bring it an economic benefit. In other words, it is everything that either is money, or is likely to bring in money.
Current Assets are cash, or anything that is likely to be converted into cash in the next twelve months. Trade debtors are a key example. They are amounts that customers owe you. Usually you expect your customers to pay you within 12 months.
Non Current Assets
Non-Current Assets are assets that are likely to provide a benefit over a period of longer than 12 months. Generally this includes things like buildings and equipment.
Liabilities a company’s liabilities are everything it owes. This is usually money the company owes, but it can also be goods or services if a customer has paid a company and not yet received what it paid for.
Current Liabilities are amounts owed that need to be settled within one year. The most common example of these is trade creditors, which are the suppliers who provide you with the things you need to produce whatever goods or services you sell.
Non-Current Liabilities are liabilities that will eventually need to be settled, but not this year. For example if you have a long term bank loan, the amount due in the coming 12 months is a current liability, and the rest is a non-current liability.
All of a company’s assets minus all of its liabilities equals its owners’ equity. This essentially represents the total value of what the company owns. Note this is distinct from the value of the company as it does not take into account the company’s ability to make money. Owners equity can be made up of lots of different things, but in a small company it is generally just share capital and retained profits.
The share capital of a company reflects the ownership percentages of the company. For example if you own 50% of the shares of the company then you own 50% of the company. However the value of the shares on the balance sheet bears no relationship to the actual value of the shares or the value of the company. Shares very often have a par value of one pound. Their actual value is the value of the company times whatever fraction of the share capital the share represents. So if a company has 100 shares of £1 each, but the company is worth £100 million then each share is actually worth £1 million. This value is not reflected on the balance sheet as it is subjective and constantly changing.
Retained Profits (or losses)
This is the historical total of each year’s profits or losses of the company, minus any dividends the shareholders have taken out of the company.
When a company pays dividends what it is actually doing is paying its profits out to its shareholders. Dividends can only be paid out of retained profits, so if a company does not have retained profits it cannot pay dividends (technically it can also pay them out of share premium reserve, but that is a bit complicated for today).
Balance Sheet - slightly more advanced
Assets on a balance sheet can be both tangible or intangible. Tangible assets are actual physical things and in most cases their amount on the balance sheet is how much the company actually paid to get them.
Intangible Assets are stores of value not represented by actual physical objects. They include the value of brands, patents and intellectual property. Intangible assets are notoriously difficult to value and to turn quickly into cash, and therefore can be open to some manipulation by unscrupulous business owners. Be very cautious if you evaluate a business with high current liabilities, ie it needs to pay lots of money out quite soon, and these high liabilities are matched on the asset side by high intangible assts. There is a good chance such a business will run out of money very soon.
"... Be very cautious if you evaluate a business with high current liabilities...matched on the asset side by high intangible assts. There is a good chance such a business will run out of money very soon...."
Financial jargon is endless, and evaluating the value of a business is an industry in its self. However if you know and understand the above numbers you’ve at least got half a chance of getting a dragon on board to help you.