On April 10, 1912, the RMS Titanic set sail from Southhampton, England on her maiden voyage across the Atlantic Ocean to New York, with 2,200 passengers and crew. Dubbed “unsinkable” due to its unique hull, which had a double-bottom, sixteen watertight compartment design, the Titanic steamed toward its destination at 22 knots per hour. Despite the urgent warnings of lookouts Fred Fleet and Reginald Lee (“Iceberg, dead ahead!”), the helmsman was unable to react quickly enough to avoid a collision with a large iceberg. The ship struck a glancing blow just off the coast of southern Newfoundland at 11:40 p.m on April 14th, tearing a hole in the hull. By 2:20 a.m., the ship had slipped under the water, taking with her 1,516 victims.
In small business, the ship is your company. You are Captain Edward Smith, navigating through dark, choppy waters. Perils lie ahead. It’s your job to avoid them before they turn your company into something that James Cameron confuses for a love story but inexplicably manages to win eleven Academy Awards for anyway.
Don’t be a victim. For that matter, don’t be a ship taking on water, or for that matter, don’t blindly steam toward an iceberg. The following are seven indications that your small business may be sinking and what to do about them.
Negative cash flow
On an episode of the classic television series Cheers, Harry the Hat is staked by Sam Malone to win back Coach’s money from a swindler in a card game, and yet is losing his ass rear end (Sam’s money) to said swindler instead. When questioned by a nervous Sam, Harry waves his hand and says, “It’s okay, I’m toying with him. Giving him a false sense of security.” Sam points to the bad guy’s large pile of chips and quips, “That looks like a genuine sense of security!”
Have a true understanding of your cash flow. Gauging things by revenues — or worse still, store traffic — is just half of the equation. As a general rule, you should have enough ongoing cash generated (generally defined as profits plus depreciation plus interest expense minus owner’s distributions) to service your loan payments by a factor of 125% or greater. If you’re at 100%, at least you’re treading water. Below that, you’re a sinking ship. Iceberg, dead ahead!
What to do about it: Short of arm-twisting rich Uncle Joe, the answer is to increase revenues and/or decrease expenses — preferably both. Get rid of unprofitable or low-margin products or services and focus on things that sell in today’s economy. See if you can refinance debt to lower your monthly outlay and take a good, hard look at how many employees you need. Consider reinventing your business to generate buzz: host PR events, offer free classes at night or on the weekend, partner with other businesses in your local area to cross-promote one another. Do what you can to slap a metaphorical ‘coat of paint’ on your business in order to freshen things up.
Diminishing gross profit
Gross profit is defined as revenues minus cost of goods sold. Measured as a percentage of sales (gross margin), it can vary from year-to-year and industry-to-industry, but one thing is certain: if your margin is on a declining trend, you’re making less money. And making less money is bad.
What to do about it: Get that margin where it should be. Lower your cost of sales or increase your prices. Find a cheaper vendor for your inventory or charge more for your goods or services. If you want to know what’s acceptable for your industry, head to the library and check out the latest version of RMA’s Annual Statement Studies, which will show you exactly what the industry percentages are.
Like a true seaman, Captain Smith believed the honorable thing to do was to go down with the ship. It’s not.
Increasing debt in relation to equity
If not properly managed, debt is the silent killer of small businesses. It can slowly build to the point where the company is unable to achieve structural profitability, with too much of the business’ available cash devoted to debt obligations.
Like water filling the Titanic, your business will sink if the situation isn’t rectified. Rule of thumb: have no more than about four dollars of debt for every dollar of equity on your balance sheet.
What to do about it: Pay down your debt as quickly as possible. Your net worth improves with every principal payment you make. Make unscheduled principal payments as often as possible to whittle the figure down. Although you are paying creditors, by improving your net worth you are (in effect) paying yourself.
Low liquidity ratios
Two ratios to keep an eye on are the current and quick ratios. The current ratio is calculated by taking current assets (cash, inventory, accounts receivable, other short-term assets) divided by current liabilities (accounts payable, current portion of long-term debt, accrued taxes, other short-term liabilities). The median figure varies per industry, but in most cases should be north of 150%. The quick ratio is the same calculation, minus inventory from the numerator. Ideally, that figure is something around 100%, but once again, varies per industry.
If your ratios are well below these general benchmarks, you may be forced to take on debt, which we just discussed in the section above. Debt can be a useful tool, but not when acquired out of desperation.
What to do about it: Build a reserve. If that’s not feasible, a business line of credit is a fine tool provided that you pay it down regularly.
Late payments and unpaid taxes
If you’re struggling to pay your taxes and/or are late on payments to creditors, iceberg, dead ahead! This is the most telling sign of business distress.
What to do about it: For reasons that have yet to be explained by science, struggling debtors tend to stick their heads firmly into … the sand. Take heart: the creditor will often be motivated to work with you. Talk to them and negotiate something you can both handle.
Eating your seed corn
Selling equipment or other fixed assets to generate quick cash might be a temporary solution to your challenges, but can create large strategic or functional problems later on. Doing so is a big red flag that your businesses isn’t generating sufficient cash to pay its bills.
What to do about it: Simply stated, don’t do it. Figure out a better, more permanent solution.
Doing the same thing and expecting different results
Albert Einstein is credited with the saying we’ve all heard many times before: the definition of insanity is doing the same thing over and over again, but expecting different results. Whether Mr. Egghead actually said that isn’t relevant — in the big picture, you need to make changes if things aren’t working.
What to do about it: Think about it. You’re in business for yourself, which proves you’re a risk taker. And yet you’re worried about changing things because of the risk of changing things? Get off your duff, make the adjustments you need to make, and if they don’t work, make better ones. Like a mad scientist, keep tinkering until you get it right.
Avoiding icebergs
Although you’re bound to sail through iceberg-infested waters at some point in your business’ life cycle, you can steer of potential disaster by paying close attention to the warning signs. Learn to read your financial statements, get your margins and cash up and your debt down, don’t eat your seed corn and for God’s sake, don’t wait to make changes if things aren’t working.
Oh, and don’t be Captain Smith either. James Cameron peaked with Aliens.
