Starting With Sales
A better understanding of your small business financial statements starts with sales, the top line of the income statement.
Over time, small business owners develop an intuition for how their business works: what they can sell, what they can charge, what their inputs cost, what their expenses and margins should be. They use this mental model to make the everyday and short-term decisions that keep their ship afloat, if not exactly on course. Sure, they’d like to understand and use the financial statements prepared by their year-end accountant, pull back and see things from a higher level — maybe spot and fix the leaks, maybe steer toward a goal — but there’s too many numbers, too much jargon, and the accountant charges by the hour. Leave the accounting to the accountants. There’s a business to run.
This was precisely my attitude. But I was helping to run a bookkeeping and accounting business — one that preached the importance of timely financials for goodness sake! We were producing monthly financial statements for hundreds of clients across Canada. Meanwhile, I couldn’t have told you very much about our own financials, basic questions like where did the money that came in go, was our business generating cash; or more nuanced ones like were we, as owners, getting a reasonable return on our investment. I focused on the areas of the business that I understood. It’s clear to me now that, by neglecting finance, I was playing at being an entrepreneur, rather than actually being one.
Thanks for reading origami.ca! Subscribe for free to receive new posts and support my work.
Eventually I was forced to realize an entrepreneur needs to do more than assume a single function role; that siloed, short-term-only, keep-it-all-in-your-head management stalls progress (and growth) once a business reaches a certain size. Past this point, the longer term needs to be planned; the business needs a more professional approach to management and finance. Without financial understanding and planning, the long term either never arrives (you stay stuck in the short-term loop) or it shuffles up in a shape you won’t expect or welcome — forcing you to ask, is this what all that was for?
This will be the first in what (I hope) will be a series of posts following me, an entrepreneur who reached his limit while taking an intuitive, finance-lite approach to running and growing a business, as I try to learn what financial statements say about a business, its performance, its health, and its prospects. Along the way, I’ll try to show how to put the pieces back together to get a clearer view of a business’s present financial state, where it comes up short, and what can be done about it. And finally, I hope to show how small business owners can use their financial statements to make plans, set goals, and work steadily toward a better financial future — the basic reason any of us start a business in the first place.
This post, the first in the series, will be on sales, the top line of the income statement, a line every small business owner understands and watches carefully. I’ll cover a couple of prerequisite steps an entrepreneur needs to carefully consider before pursuing sales. First, an entrepreneur has to decide what type of business he’s in, what his business is going to offer customers; the business needs to come into focus before he can secure the capital needed to cover initial asset purchases and other upfront costs. Second, in order to create that focus for his business, an entrepreneur needs to understand his business’s target customers and the problems it’s going to be solving for that group. Once I’ve covered these prerequisites, I’ll describe a useful technique for breaking down sales into component parts that can be experimented with in order to grow the top line.
The story of the business
The income statement basically tells you whether your business makes money, that is, profits. Sales is the first line on the income statement, so, in a sense, it all starts with sales. But, for a new business, the first financial transactions typically appear on the balance sheet, and they reflect what a business is setting out to do. Money gets deposited into a business bank account and becomes the company’s first asset. The same bookkeeping that records the deposit records the source of funds for this asset: as equity if the capital came from owners or outside investors, as a liability if the capital came from creditors. This initial capital is used to purchase the assets the business will need to make its products and to deliver its services. The financial effects of all this business-defining startup activity is logged by bookkeepers to balance sheet accounts rather than income statement accounts.
Apart from purchasing assets, the initial capital is also used to pay for the startup expenses the business incurs. These are transactions that appear on the income statement before the first sales dollar hits the coffers. Before the curtain lifts, the script has to be written, the set designed and built, the actors, crew, and director hired. Costumes, props, lighting, sound, promotions: all the behind the scenes details required to stage the business according to script — all of which have to be paid and accounted for before cash starts to flow in rather than out.
It’s possible to start a business with very little capital. Think consultants and contractors, and service businesses that launch with a minimum bank balance, some redeployed personal assets, some know-how, and some get-up-and-go. It’s possible but not advisable. Lack of funding is one of the biggest reasons small businesses fail. Markets are competitive. They’ll drop the new guy when he makes a mistake; put him in a chokehold and squeeze until he taps out. Capital, enough of it, gives the breathing space an entrepreneur needs to fight free, get back up, and survive to the next round. That’s a big part of what capital (or access to capital) represents to a business at any stage: breathing space.
How do you access capital then? From folks who have it, obviously, and you can list off research, analysis, business plans, forecasts, and contracts — all the tools and apparatus investors and creditors use to deal with uncertainty in their line of work — but capital ultimately gets deployed because someone tells a story that someone with capital believes. They could be the same someone or they could be different someones. One tells the story of the business: what it does, how it does it, who it does it for, why and how much it gets paid, what it is, and what it will become. The other believes enough in the story and the person telling it to venture their money to bring it to life. A good business story rings true.
Before a business starts selling, then, it has to set the stage. And before that, it has to have its story, a story that’s compelling enough to attract capital and move people to take action. The story can prove to be wrong, it can change over time, but the people involved have to know what it is, what they’re in it for, at any given point in time.
The story of the customer
Because every sale involves a purchase, the story of the business is mostly the story of the customer. “Without customers in sufficient and steady numbers there is no business and no profit,” Theodore Levitt writes in The Marketing Imagination. All the prep work, setup, and staging is premised on the belief, the theory, really, that there is some group of customers in a competitive market that will value what the business offers enough to pay the price the business intends to charge. How can a business be sure the group of customers exists? It can’t. It’s a theory that has to be tested. The theory could be a little off or entirely wrong. Risk and experiment are always a part of business. Levitt explains how a customer focus helps a business manage risk:
The purpose of a business is to get and keep a customer. Without solvent customers in some reasonable proportion, there is no business. Customers are constantly presented with lots of options to help them solve their problems. They don’t buy things, they buy solutions to problems. The surviving and thriving business is a business that constantly seeks better ways to help people solve their problems — functionally better, valued better, available better. To create betterness requires knowing what customers think betterness to be. This precedes all else in business. The imagination that figures out what that is, imaginatively figures out what should be done, and does it with imagination and high spirits will drive the enterprise forward.
Most small businesses serve local or regional markets. They don’t have a competitive advantage that resulted from some sort of innovation. They would be considered one of “lots of options” customers have to solve their problems. They get customers by setting up in markets that have enough customers for what they have to offer —customers who aren’t already committed to competitors — and then getting the word out. They keep customers the old-fashioned way, by giving them what they want. That could mean convenience, low price, distinctive products, high quality, or great service. Each business targets a group of customers that occupy some region of this multi-dimensional “value” space.
It takes imagination (and talent… and luck) to get it right: to explore this customer “value” space, see an area where customer needs aren’t being adequately served, and tailor a business to serve exactly those customers and their needs. Low price means the business has to be about low costs and high volume. Distinctive products require innovation or exclusive relationships with suppliers. Service and quality require care and attention on the part of the entrepreneur while creating and overseeing the business. Each dimension offers a way of making the story of the business stick in the target customer’s mind. Each dimension potentially answers the question: How do we stand out? “The surviving and thriving business is a business that constantly seeks better ways to help people solve their problems.” That is to say, a business that’s careful in crafting the story of its customers.
The sales equation
Once the setup work is done, the doors open, customers (hopefully) file in, and sales start. Sales is one of two numbers on the income statement that tell small business owners whether the story of their business is closer to true or closer to false — the other number being the bottom line: profit. Sales measures the market response (does the market care about what we offer?) and profit measures the business’s ability to capture some part of the value generated from the market response (can we make money with our offer?). Low sales and low profit is obviously a bad sign, but high (or a reasonable level of) sales and low profit is also a concern. This indicates there’s something wrong in the setup that needs to be addressed, whether in pricing or in the costs and expenses incurred to generate that level of sales.
The movement of the top line number will be closely watched on opening day and every day after, like the vital signs of a patient under observation. We all want to see our sales moving up, that’s a sign of health. Rapidly up is exciting but stressful. Steadily up is less exciting but less stressful. Just as long as the direction is up. (If the business is seasonal, you’ll still want to see that the sales from a given period this year are up from the same period last year.) How does that (sales going up) happen? What can we do to make it happen? What are the drivers?
For me, the most useful customer-focused way to break down sales into components that can be individually experimented with and reasoned about (a way that works across most industries) is the following:
Sales = Customers * (Visits / Customer) * (Sales / Visit)
This is a simple count of your customers. More customers lead to more sales. You can refine the count further into new and returning customers. New customers are acquired through advertising, promotions, word-of-mouth, referrals, content marketing — anything and everything that gets you a sliver of attention from your target market. Returning customers are acquired by creating great first and ongoing experiences. If you’ve done the work of creating a business that fulfills real customer needs, and you’re doing the work of getting the word out, you should be seeing increasing customer counts.
Visits / Customer:
This is a measure of customer engagement. If it fits with your business model, you’ll want your customers to visit your business multiple times in a year. More visits lead to more sales. This requires marketing and advertising to existing customers via email, direct mail, or social media, or, where it makes sense, adopting a subscription model.
Sales / Visit:
This component measures two things: how much of your product or service offering your customers purchase on average, and the average price you’re able to charge. You can increase this component by getting customers to buy more of what you have to offer, whether that means buying more of one thing, buying a wider variety of things, or a combination of both. Or you can increase it by charging a higher price for the products and services you offer. The first option requires work on developing your customers. This works best if they’ve had positive initial experiences that makes them willing to sample your other offerings. The second option usually requires you to have some type of competitive advantage that overcomes resistance to higher prices. It could also be a function of realizing that you’ve been underpricing relative to the market — and then stopping that.
A small business can move the sales needle by improving in any or all of these customer relationship measures. Even if you run a small business that doesn’t track sales at an individual customer level (if so, why aren’t you?), it’s still useful to conceptualize sales this way, because it forces you to think about your business from a customer perspective and to focus on the customer story. For the third time, “The surviving and thriving business is a business that constantly seeks better ways to help people solve their problems.”
Also, the sales number on an income statement prepared for one time period can only tell you so much. You’ll want something to compare the single period number to: sales in the previous period, sales in the same period last year, or the forecasted or target sales for the current period. You’ll also want to see how sales are trending over a number of such periods. Those periods can be days, weeks, or months for actively managing the steps you’re taking to support sales. They can also be years when you’re taking a step back and looking at your business from the perspective of an investor. Is there still a good growth story here or has the business plateaued?
Finally, sales interacts in interesting ways with many other numbers that appear on your financial statements. These relationships are examined in the field of financial statement analysis. I’ll try to cover the important connections to be aware of as I work through this series.
The bottom line
Remember, in the end, the purpose of a business is to maximize its profits. You’re almost always going to need more sales. Or at least it’ll feel that way, that more sales will lead to more money, and more money will solve more problems. So there’ll be a temptation to underprice to generate those extra sales. It’s the easiest route after all.
But the reality is the business doesn’t need more sales. It needs more bottom line, more profit. And that comes from more margin, which you sacrifice when you discount and underprice. Your job, as an entrepreneur, isn’t to get more sales, it’s to get more sales at your required margin. It’s a subtle difference, one that’s easy to overlook. But it makes all the difference — between a struggling, surviving business and a thriving, growing one.
Thanks for reading origami.ca! Subscribe for free to receive new posts and support my work.