The Financial Goal
Of Successful Small Business
What is the financial goal of a successful business? For investment, modern investment theory says that you can fix a level of portfolio risk and seek to maximize the return the portfolio yields compatible with the set level of risk. Or, conversely, you can attempt to fix a reasonable level of return and minimize the level of risk associated with achieving that rate of return. Of course, these theories work out better in academia than in the real investment world where they are notoriously difficult to implement!
But, if you were to try to summarize the financial goal of your business using only one criteria, what would it be? Some might answer that the goal is to maximize profits. In an attempt to increase profits, some companies try to generate more and more revenue, even if the added revenue is less profitable than existing revenue. This results in lower profit margins.
If your sales triple and your profit margin drops in half, profit-wise, you come out ahead. For example, going from sales of $5 million and profit margins of 10% ($500,000 profits) to sales of $15 million and margins of 5% ($750,000 profits) increases profits by 50%.
But, is this truly desirable for most businesses? Low margin businesses usually involve higher risk. While companies are keen about measuring profits, few companies are as concerned with measuring the level of risk the company is taking to achieve the current level of profitability. Profits and profitability aren't the same. So, too, some companies take much greater risks to earn their money.
Lower margin companies are less resilient to increasing costs and changing market conditions. A drop in sales for a store operating on thin 2% margins often results in absorbing financial losses. And, there isn't only a quantitative difference between operating a business that is making money and a business that is losing money. There is a qualitative difference. The business which is making money can continue indefinitely. The business which is losing money only has so long before financial reserves run out and it must cease operations.
Similarly, some companies sacrifice customer care and product quality in an attempt to increase current operating profits. However, such behavior often leads to lower customer satisfaction and lower future sales. Reputation is compromised, and the company's future profits decrease. The current profit and loss statement doesn't show the real devaluation which has occurred to the company. Nor does the balance sheet.
Another possibility is maximizing the long-term value of your business as an ongoing concern. Measuring this value is difficult, if not impossible. It involves at least three factors. First, the current profits the business yields. Second, the estimated future profitability of your company based upon your company's reputation and future capability. And, third, the level of risk inherent in how you operate the business.
Whenever you plan to increase present profitability or profits for your company, ask if your actions will compromise future profitability or increase the risk inherent in how you are running the business. Keep an eye to the long-term value of your company. You will invariably have an idea of whether your actions are increasing or decreasing your company's long-term value.
For example, in an attempt to improve the return on equity (ROE) of a business, some business owners borrow money to leverage operations. As long as the borrowed money can be put to work earning more than the interest rate you are paying, you come out ahead profit-wise and the ROE increases.
However, most knowledgeable small business owners are leery of borrowing too much money. They inherently know that debt increases the danger of a business failing. If sales drop, for example, the interest keeps accruing. That interest and principal must be repaid, even if the use to which the money is put doesn't generate an adequate rate of return. Trade credit which varies with sales is the safest form of company borrowing.
Yet, debt isn't completely bad. During good business conditions, adding a bit of debt allows the company to earn more money. These added earnings can be saved as capital for a rainy day.
Especially for cyclical companies, such as automobile manufacturers, retained and conservatively invested capital is crucial to long-term survival. Automobile manufacturers are notorious for earning billions of dollars during good economic times and, then, losing billions of dollars during recessions.
Similarly, financial reserves give a margin of flexibility and safety to a small business. However, small business owners tend to be very one-sided when viewing financial reserves. Small business owners love watching the financial reserves pile up. But, as soon as business conditions degenerate, small business owners hate watching financial reserves dwindle. There is a feeling of failure, a feeling that all that was worked for is in jeopardy. A thought that closing the company and getting out while the getting is good might be the best move.
Rather than viewing financial reserves as necessary to the normal operation of a business, they have come to view the reserves as part of their personal return on their business investment. In the worst cases, extra profits during the good times have been paid out to the business owner and invested in such necessities as a Porsche. Then, when the bad times hit, the business doesn't have the financial reserves to continue operations.
To be financially successful in business, most small business owners will need to operate their business for many years. It is in the later years when the equity base is large that the biggest financial return will be earned. This is why it is so crucial for your company to maintain a strong financial position which will allow it to repay debt quickly if business conditions change. You need to be able to stay in business.
Extra capital retained within a business can also be ventured on new products or marketing strategies to grow your business. Many new entrepreneurs say, "I've got a great idea for a business. It's a sure thing. It will generate huge financial returns."
This usually portends a loss of capital. Had the entrepreneur acknowledged the loss of capital was a real possibility, he might have done things differently. For example, maybe the individual wouldn't have been so quick to mortgage his home heavily and fully deplete his 401(k). The money he risked was not appropriate "venture capital."
The small business owner's best source of "venture capital" is the extra profit your current company has generated. Effectively reinvesting this money is a key to financial success. Effectively reinvesting this money will give the greatest chance of growing the long-term value of your company.