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Preview content from Greg Crabtree’s groundbreaking new book, Simple Numbers, Straight Talk, Big Profits!
Every business starts with the seed of an idea, but only a few entrepreneurs can visualize the field all the way through the harvest, much less through many successive seasons. By seeing beyond the numbers, I have laid out the basic principles that can help entrepreneurs create a realistic vision of their business from the beginning through many bountiful harvests.
I will share my experience on how to lay a solid foundation to build and manage your business, which is based on hundreds of real businesses, not cocktail party advice. We start with your dual role of key employee and shareholder and how something so seemingly simple can mess up so many businesses. We then move to learning the connections among profits, cash flow, and the productivity of labor.
If you feel that your business is sucking the life out of you, you’ll learn why the black hole phase of business exists and how you can get beyond it to smoother sailing. With profitability comes taxes, and I will show you how to fearlessly face the tax monster under your bed. Once you get the broken parts of your business fixed, you need a monitoring system that is simple and constantly pulses the right data at the right time. At this point, you’ll understand the economic value of your business and have a clear vision of whether you should offer stock to partners or employees, sell the business, or keep it healthy and harvest the profits to build your own wealth.
This book is primarily aimed at business owners from startup to $5 million in revenue. However, you should read this book before you even start a business. Many of my peers in the Entrepreneurs’ Organization who have a business with revenue beyond $5 million have found the concepts clarifying and valuable.
Chapter 1 – Owner’s salary: why your salary and distributions are fogging your view of net income
I’ve always felt that accountants make finances too hard to understand. In my practice, we look at numbers in a simplified way and use entrepreneur speak to simplify the concepts. This seems natural since we’re entrepreneurs ourselves.
When I started brainstorming for this book, I was stunned when I realized that I had never seen my first key topic discussed in any book about entrepreneurial success. That topic is the owner’s salary. It’s a tremendously important concept, but entrepreneurs often misunderstand the relationship between their salary and the return on what they own. In fact, all of my clients have confused the profits of their business with their salary. Remember this key distinction: You get paid a salary for what you do, and you get a return on what you own.
Why is this so important? Because when you don’t pay yourself a market-based wage, your net income number is lying to you. Or rather, you are lying to yourself. Until you pay yourself a market-based wage and plug that number into your financials (a number that’s reasonable – not too high or too low), your financial data is worthless. It’s like having a compass that’s five degrees off in every direction. If you don’t include a realistic wage for yourself in your financials, your business will always head in the wrong direction.
Deciding on an appropriate wage for yourself is really a key building block for your business. As we’ll see, it will help clarify a lot of other issues. But don’t just take my word for it. Occasionally, I’ll use actual questions and answers from the entrepreneur classes I teach to illustrate key points, like the following exchange:
Entrepreneur: Can you give me an example of how paying yourself a below-market salary distorts financial numbers?
Greg: A great example involves one of my clients. They are a couple and co-owners in a business. They were patting themselves on the back because they were making a net income that was more than 20 percent of sales. Or at least they thought they were. Unfortunately they were paying themselves a very small salary and taking distributions out of the business. After I added their salaries and distributions together and treated this number as if it were a true market-based wage, they were actually only making 5 percent before taxes.
This happens constantly in businesses. Most entrepreneurs thinks they are overpaying themselves, but at least 90 percent are underpaying themselves. I think this is common because entrepreneurs want to show off their peacock feathers in public, and they use sales numbers and net income for their first extravagant display. But sales figures and net income are irrelevant if business owners don’t include a true market-based wage in their financials. As the old saying goes, “Sales are for show, profits are for dough!” That’s why so much of the data in the marketplace – whether it is industry data or comparative data among other industries – is worthless. Until you apply the market-based wage filter across that data, none of it is relevant. If you’ve been in business for yourself for a long time, you receive a Social Security wage statement either once a year or every two years (depending on your age). Look at that statement, because it tells you what your W2 earning totals have been over time and what your estimated Social Security payments will be when you retire. This can be a very sobering thing if you decided that you would make low wages and distribute the profits of the business to yourself.
Chapter 2 – Profit: Why 10 Percent is the New Breakeven
You know that you have to pay yourself a market-based wage and get a return on what you own. If you’re not at the point where you can do this, then you’re not profitable enough. Maybe you’re thinking, “I’m committed to my business, and I want to pay myself a market-based wage for the things I do. But I’m not getting enough profit out of the business to be able to do that.” How do you fix that problem?
First you have to understand the concept of profit. Profit is the lifeblood of every business. If your business isn’t profitable, you’re taking business from others and you will eventually fade away. You either have to be profitable or have an endless amount of capital to throw at your business. To keep it simple, when I say profit, I’m talking about pretax profit. This is the profit you make after you take all your sales minus all your costs, before you pay taxes.
If you can’t pay yourself a market-based wage, the first thing to focus on is getting your business profitable. Remember the cow analogy in chapter 1? You can keep your cow healthy and milk it every day, or you can have one big barbecue dinner. Think of the milk as profit. It eventually turns into cash flow, but you have to be profitable first.
A lot of business books and articles use the term EBITDA, which means earnings before interest, taxes, depreciation, and amortization. There’s a game, largely played in the investment banking community, where they recast earnings and say that interest, depreciation, and amortization aren’t real costs. But let’s face it. Unless you’re building a twenty-year production plant that is going to last fifty years, depreciation is a real cost. If you buy a truck for $50,000 and it wears out in five years, you’ll have to replace it. That’s a real cost. Amortization is just a fancy term that spreads the cost of nonequipment over years just like depreciation, but very few entrepreneurs deal with amortized costs that are significant.
Technically, interest is not an operating cost. Generally accepted accounting principles (GAAP) are great, but at the end of the day entrepreneurs need to be practical. When you write a check for interest, you have to pay real money to cover that check. It takes cash out of your business and typically indicates your business is undercapitalized. This is an important aspect of interest, and it’s the key reason I focus on pretax profit.
Pretax profit is your earnings before taxes. That is the revenue-generating activity that your business produces for your benefit. In most of the businesses I work with, interest, depreciation, and amortization are real numbers, so it’s important to understand that you should ignore EBITDA and focus on your pretax profit.
As I said in chapter 1, revenue is for show, and profit is for dough. I couldn’t care less how much revenue you have. It’s an important number in terms of cash turnover, but we need to focus primarily on your gross profit before we can fix your pretax profit. Gross profit is revenue less costs of goods sold. Contrary to many other accountants, I recommend that you not include any labor costs in getting to gross profit. By keeping labor out of the equation, my definition of gross profit gets you to the number that is the true economic engine of the business.