When Profits Could Be Bad News for Your Design Firm
I could give, and have given, many lectures on the difference between profits and cash flow. And while a key success factor for an interior design firm is to increase cash flow over and above what the business requires to operate, it is sometimes easier to focus on profits at first. That’s because it is “profits” that most business owners see on their monthly P&L statements.
What few design firm principals understand is that while a dollar of cash is a dollar of cash (cash is fungible, as they say) a dollar of profit is not a dollar of profit. Dollars of profit should be viewed very differently depending on several variables, most notably, the quantity (what P&L statements show) and the quality (which no statements show.)
Said again, the “quality of profits” cannot be found without some analysis that few business owners and few accountants think about or know how to do. Since I want you to become hyper aware of the quality of profits, let’s look at the 4 stages of profits. Think deeply about which stages seem familiar to you from the past, where you are now, and where you want to be in the future.
Stage I Cash Crunch. The firm has not only used up most of its cash reserves, but it has tapped out credit cards and credit lines as well. Payrolls have gone or may go unpaid. Vendors may put the firm on COD. Getting to this point is generally a result of managers lacking finance and accounting acumen and not bringing in those who have it. Otherwise, the problem would have been caught and warded off sooner. Immediate turnaround tactics are essential for this firm.
Stage II Cash Shortfall. This is essentially the same scenario as the Cash Crunch, but disaster is not quite as imminent. While cynics might refer to this as “shuffling deck chairs on the Titanic,” it is still possible to move things around, stall on other things, give up on yet other things, and keep the lights on for a while. While the crunch has not yet hit, the trained eye of the professional creating a 3-6 month forecast, will see the crunch is coming if actions are not taken immediately.
Stage III Quantity of Profit. When profits can be "bad," is when the mere bottom line "number" looks good, but what remains hidden is that the firm is suffering some erosion of profit margins in recent times. Reduced margins can be a sign of creeping overhead or what I’ve described in other write-ups as the “moving breakeven point.” This is often caused by an increase in sales causing principals to bring on more staff and other overhead just as sales once again decline. We could consider these profits as "low-quality profits."
Stage IV Quality of Profit. If profits are of high quality, managers have far more time to develop new plans and strategies without falling into one of the other stages. High-quality profits are measured by certain financial ratios that take into account such things as how efficient the firm’s employees are (gross profit per employee, for example) and how efficient the firm is in utilizing overhead and infrastructure. (Net profit as a percent of total overhead, for example.)
Whether are not these key ratios are consistently getting better or worse over time can be the key elements of an early warning system to prevent falling into the less desirable stages in the future. I've consulted for firms and by looking at just 3-4 years of comparative financial statements have discovered a clear reduction in the quality of profit as margins began to shrink on jobs.
A truly savvy principal will learn to recognize, and to develop plans for all four stages, so that action may be taken the minute it appears the firm may be slipping into a less desirable stage.
Assignment: Simply compare your firm's overall gross profit margin over the past 3-4 years. If there is a consistent downward trend, please don't rationalize. Instead, set a hard and fast goal to improve it by at least 1% in the next quarter. Then, rinse and repeat!
More Help: My six-week course on "Getting Pricing Right" can help you to quickly optimize your pricing strategy which is the fastest way to an improved gross profit margin and higher quality of profits. Click HERE to learn more.
Coaching and Consulting: If you'd like to explore working with me one-on-one, please click HERE for more information and to schedule a complimentary call if you qualify.
Now, go earn what you deserve!