There is a quote that is often attributed to Mark Twain – “Everyone talks about the weather, but no one ever does anything about it.”
I think about this quote when I talk to other agency owners about their businesses. My goal is to always deliver one simple message: Your financial performance is NOT the weather. You don’t have to sit back and wait to see if it will rain this month or not. You may not be able to control every aspect of your financial performance, but you can definitely influence it.
For some owners, their business is like a slot machine. Every month, you pull the lever, and you see what comes up. All cherries? That’s a great month! If you understand your finances, you will be able to predict your financial results. They won’t seem like such a gamble anymore.
How did we do?
Before my wife and I started our home care agency with FirstLight, I used to run factories for a living. A factory always has a budget; every department has a set amount that they are allowed to spend. Typically, that amount is broken down further into sub-categories – labor, tools, repairs, and so on.
We take the same approach with our home care agency. We have a simple spreadsheet that is broken out by month and by category. At the beginning of the year, we fill in budgeted amounts for each category and each month, then, as the year progresses, we fill in the actual results after each month’s finances are closed out.
Most businesses use accounting software that can report expense categories by month. So why create the spreadsheet?
The idea is to have a target or goal. You need something to compare your results to – otherwise, they are just numbers. Say you spent $2,000 on supplies last month. Is that a lot? Maybe you had budgeted $4,000 for supplies last month. You were under budget! But is that good? Spending less will certainly increase profit, but supplies are critical to business operations. Did something get missed? Is somebody cutting corners?
A budget provides a frame of reference that contextualizes your expenses. Reviewing your numbers regularly can lead to lots of findings like this. It can also help with keeping costs under control.
Many of us have expenses that are automatically deducted from our account each month – like a gym membership. Vendors love to get you set up on plans like this because it creates a steady income for them and because many people forget to cancel them. Creating a budget and reviewing results can lead to identification of costs like this that are no longer necessary.
When we create our financial tracker, we lay it out in the order of our Profit and Loss report (P&L), so it is easy to fill in—just 5 minutes per month to record the numbers. We don’t spend much time trying to calculate our budget for each category in great detail. The first time you do this, you can just use a run rate from past performance or take last year’s total and divide by 12. The exact budgeted number is not what’s important; having a number for comparison is.
These monthly reviews can drive your decision making. Maybe one of your office employees has high mileage expenses; would a company car cost the same and make more sense? Are your investments in advertising paying off the way you thought they would? You can also set revenue targets by month to determine whether your business is growing according to your projections.
Are we breaking even?
On the theme of understanding our financial performance, one of the key questions owners want to answer is: Are we making money? If you are not at least breaking even, then every day you operate is forcing you to invest more capital in the business.
The goal of a break-even analysis is to figure out how much revenue you need to cover your fixed costs for a specific period of time. In home care, our main unit of activity is hours billed. It is most common to translate your break-even point into hours per week (HPW). With that information, you will know every week whether you are winning or losing.
Every business has variable costs that are directly driven by revenue – the more hours you bill, the higher those costs are. In home care, the biggest categories are caregiver payroll and caregiver burden. If you run a franchised business, you may also have royalty or other franchise fees as a variable cost. Depending on your business model, other variable costs might include background checks, drug screens, or personal protective equipment.
Other costs are fixed; they don’t change rapidly in the short term as revenue fluctuates. Fixed costs include rent, office supplies, company car expenses, and office salaries. Every business owner should know what their average monthly fixed costs are, because that’s the number you need to cover to break even.
So how do you cover those fixed costs? With gross margin. You probably have a line on your P&L that directly shows your gross margin. If not, it is simply the difference between your revenue and your variable costs. Every hour that you bill generates additional margin to help cover your fixed costs (as long as those hours are profitable).
Margin contributes to covering your fixed costs. That’s how you figure out your breakeven point. For a period of time, figure out your margin per hour by dividing gross margin by hours billed. Then, divide your monthly fixed costs by margin per hour to determine your monthly hours needed to break even. Dividing by 4 (or 4.3, to account for months being slightly longer than 4 weeks) will give you your weekly hours needed to break even.
Let’s say that you calculate $8 of margin per hour. If your monthly fixed costs were $30,000, then your monthly hours need to break even would be 3,750. Your weekly hours needed to cover fixed costs would be 937.5 hours.
Now you can see every week whether you are winning or losing. You can also use the break-even analysis to make other decisions. Are you thinking about adding a salesperson? Take that salary per week and divide by your margin per hour. The result is the number of hours your business would need to add to cover the expense. Will hiring a salesperson create that much additional business?
What else is important?
Spending a little time to understand your numbers can help you not only make better decisions, but also avoid potential problems. While this article focuses on cost and profitability, cash flow is also important.
Small businesses often struggle with cash flow. If you don’t watch it, you can easily run out of money. This happened to our business early on; we had a major payor who stopped paying their bills for about 3 months. Eventually, we had to dip into personal savings and invest more money in the business just to be able to meet expenses. If a business owner has to do this without enough warning, that money might have to come from retirement savings or other accounts that you don’t want to touch.
Obtaining a line of credit with a bank or other financial institution can help, while also avoiding the need to keep too much excess cash in the bank account. If you run short on cash, you can draw on the line of credit and pay it back when business performance allows. The interest rate could be high, but you will only pay interest for the time while you are using the money. There could also be fees for accessing the cash that you’ll need to consider. Overall, it’s better not to use a tool like this too frequently. However, if the business is in danger of not meeting payroll or other expenses, the ability to remain solvent will be more important than some short-term fees or interest.
Understanding how your finances work can inform your decision making in all aspects of your business. I was talking to another owner recently who was looking at buying a competing agency in his market. As part of his due diligence, he had reviewed the other agency’s P&L and other financial documents., and he was asking for my opinion on what the other agency might be worth.
For this decision, margin per hour is the key. If he bought the other agency, he would not run it as a separate, stand-alone business. It would be integrated into his operations, and some or most of the fixed costs might be eliminated or reduced. In this scenario, it is more important to understand the margin per hour. That’s what would be directly added by acquiring the agency.
In this case, it turned out that the other agency had very low pricing—for some clients, their margin per hour was actually negative! A client like that would drag down performance. I advised him to consider whether he would be able to adjust pricing or variable costs to make those clients profitable.
What’s the Weather Like Today?
It’s critical to be familiar with the numbers that drive your business. Planning and budgeting make it easier to see when something unexpected is brewing so you can dig in further. Knowing your break-even point tells you every week whether you are winning or losing. Going beyond these concepts to understand your financial performance further will help you make decisions that will drive success for your business and prepare you for future growth.