Fear and Profit In the Margins

October 31, 2024

When I was in banker training school after college, we learned a lot about business finance.  We learned about EBITDA, and operating income, and profit margins, and leverage - and all that banker stuff.  And, in my case, because they were teaching us to be “super-bankers” we also learned about setting up new deposit accounts, and investments, and mortgages and car loans, and annuities, and even more banker stuff.  A few years into my career though, I changed banks and they had specialists for investments and annuities, and for mortgages and consumer loans, and for deposit accounts - and so all I had to do was find businesses that needed money, and see if they qualified for me to loan it to them!  

One of the biggest metrics we used for business lending was Debt Service Coverage Ratio - DSCR in banker-talk.  If, for example, a business has (or would have) total loan payments on its building and equipment of $10K / month, AKA $120K annually, we would want to see available cash flow through analysis at a ratio of 1.40x for example, or $168K.  In simple terms, cash flow is net profit + depreciation + interest, and then we would make banker adjustments to try to understand going forward cash flow.  For example, if a business is renting a space for $5K monthly, but they have the opportunity to purchase a larger space to move into - we would add back the historic rental expense because they won’t have that anymore - instead they’d repay principal and pay interest to the bank!  

The challenge is, not every business needs to borrow money, and some that do - might not be able to pay it back!  If a business has a DSCR of 2.5x or even more - it can quickly liquidate its debt and build cash reserves to purchase equipment for cash instead - they don’t need banks often or for long.  However, if a business doesn’t make profit - or the profit they make is insufficient for too-large debt service - then they’re going backward and putting the bank at risk.  Some of the special sauce I had in my career was the ability to identify businesses that were in the 1.10x - 1.40x DSCR area, but poised for further growth and expansion, with good market demand, gross margins, and smart management.  We’ll call them B and B+ customers - they were safe enough to sell to the credit committee, would be growing and need additional financing for a long time, and they weren’t as price sensitive as the A-Tier companies - so the bank could make more margin!  

Promise I’ll get out of the banker-talk shortly, only a paragraph or two more and then we transfer this talk of margins to small business.

So, as a lender, we’re judged based on a number of factors.  These include the size of your portfolio, new business generated annually, the quality of your clients, how much they keep on deposit with the bank, and the average price you’re able to command.  Some banks and bankers specialize in the A-Tier customers, but they command A-Tier pricing.  Others more enjoyed financing younger firms with less track record, along with SBA-supported acquisitions and other more-risky but higher-yielding clients - that was me.  They were more work, sometimes took more time and coaching to put together, but were more exciting and more profitable to the bank - as long as they pay you back.  

One of the big things I mentioned above that I looked for, is a strong gross margin.  If you’re a retail business, this is the difference between what you pay for your inventory, and what you sell it for.  In a service business, it’s the difference between the direct costs to deliver a service - think the cost of the labor and supplies to deliver a house cleaning vs the cost to the client for the service.  All these individual transactions add up, and then the gross margin dollars are used to pay for all the overhead and operating expenses - the rent, utilities, marketing, administrative salaries, and whatnot.  

It’s easy to sell cleaning services if you undercut the market on price, but then you can’t pay your staff properly and face staff turnover, and you don’t have enough margin to cover the business overhead and operating expenses.  That’s why the most common advice I’ve given over the years is “raise your price” - and that’s because costs always go up, and so does overhead as you build a larger business and team.  And - your service quality has to go up alongside your price, and raising prices is scary!  

But, this post isn’t solely about margin as it relates to price or direct costs - margin is also relevant to your expenditures, and your time!  For example, most have noticed the changes in the restaurant industry the last decade or so - where the QSR (Quick Service Restaurant) model has dominated most of the growth in both national and local concepts.  Counter service ordering, go pick up your food and bus your own table when you’re done please - oh, and choose 20%, 25%, or 30% tip option please with your payment to help subsidize our payroll!  

This is a response to labor being both less abundant in the entry level market, and more expensive.  So, whereas a full-service restaurant may have staffing costs of 30 - 35% of total revenues, QSR’s target a 25% ratio.  With costs of goods sold for food often in the 30 - 35% range also, a fine dining restaurant may have as little as 30% of its revenues available to pay rent, utilities, marketing expenses, and all the rest - which is not a comfortable margin especially when fixed costs are high.  

I mention time in part because that’s what I’m thoughtful of as I write this - the blog is due to my team tomorrow!  And, because it has long been an observation that too many business owners and leaders don’t give themselves enough margin of time.  They’re so busy doing - working in the business all day, catching up on emails in the evening when they’re not chasing kids off to sports events and activities - that they don’t spend much time on or for themselves.  And yet - many of the most effective leaders I’ve known are also incredible athletes in some form or another.  Runners, bicyclists, triathletes and Tough Mudders, and even golf and pickleball if you consider those to be sports - they all require intentional time engaged in a physically and mentally challenging activity - that isn’t your work!  And somehow, people who give themselves margin for these activities often perform at a higher level than their workaholic peers!

I’m sure I’ve mentioned it before, but one of the challenges we’re working to overcome at LoCo Think Tank is the “Colorado Slow Maybe” - which is when a prospect for membership doesn’t say no - but doesn’t say yes - and usually their excuse is about the time.  “I don’t have time right now, but I’ll keep you in mind if things change, and sure - you can call on me again in 6 months.”  And, because I’m the kind of guy that stands around hoping the girls will ask him to dance - I usually follow up about 18 months later - and nothing has changed.  In many cases, I know - and so does my prospective client - that some intentional time away from the business - to work on the business - could make a real difference, but change is hard, and creating margin is scary.  But, as a business owner, a key hat you wear is to find or create better margins in your business.  

It’s an interesting irony that most businesses start because someone said yes, and often they grow by saying yes over and over before they start to say no.  And then, to keep successfully growing, they have to say no to more and more things - no, I don’t have to be the HR person, bookkeeper, head of marketing, and operations manager - and in fact, I can’t! 

But - saying no to each of those things is scary!  And so is building a team of people that can do each of these things better than the owner, and finding enough customers and margin to pay them all!  

Because of my banker training, when I look at a set of financial statements, I see the patterns in the numbers, and with a little math I can show the gross margin, the labor expense %, occupancy costs monthly, selling costs and marketing costs as % of revenues - all the banker stuff I was trained and experienced in.  I can calculate DSCR and traditional cash flow, and modified cash flow, and global cash flow - all the things.  

And - because I’ve been under the hood with so many business owners during my time in banking and in the many dozens of LoCo chapter meetings I’ve been a part of - I recognize that what those numbers actually represent is activities.  X number of customers with an average spend of Y = Z total revenues monthly.  X number of employees at $Y average hourly pay = Z hourly payroll load.  X sq. ft. of leased space at $Y / sq. ft. NNN lease = Z occupancy cost.  

To find more profit, you’ve got to do more things with the same team, or charge a higher price without incurring higher costs, or find more customers with a lower marketing spend, or…there are so many options available - the clues are in the numbers and they’re found in the margins.   

Getting into your numbers can be scary, but it’s one of the best ways to find margin.  It’s similar but different than getting into a LoCo Think Tank chapter - which is also a bit scary and a good place to find margin.  Margin to work on your business, perspective to see your challenges more clearly, space and time to consider other people's challenges, a safe place to build relationships and be real about your goals and opportunities.  
Don’t be afraid - apply today!


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