The financial system is the final post of a 5-part mini-series on the four systems that your business is comprised of.
Want to get all caught up and get more context?
And Part 4 – The Importance Of The Back-Office System
In this article, I want to cover the missing piece of the puzzle:
The Financial System
As a private company, we are under no obligation to do this. But we believe in being transparent and helping upcoming agencies that would appreciate some type of industry standards.
If you check them out, you’ll see that we grew by 134% from $1.7M to $3.94M. We also had a gross margin of 50% and a net profit of 20%.
Did we get lucky?
Are these just random numbers?
While it might seem like that, this was actually very intentional from our side. In fact, at the start of the year, our goals were the following:
$4M in revenue, 50% gross margin, and 15-20% net profit. And we hit them by…
Reverse-engineering your financial system.
I’ve been talking to many agency owners lately. And something that’s got my attention is this:
Many of them aren’t making a profit. And there are others that, even if they are, they have no idea how much money they’re really making. Or how they increase their profits. Or how much they can re-invest in marketing.
In short, they don’t have a good grasp on their financials. Which means they can’t make the best financial decisions for their company.
Do you want to have to call up your accountant at the end of the year and ask: “so, how much money do I have left over? Please, tell me there’s at least some money.”
No, you want to know what your numbers well be beforehand, right?
And, of course, there are things that have to go your way such as closing a deal. But keeping a certain profit level is something you can control.
That’s why understanding how to manage this system is so important for business owners and entrepreneurs. It gives you predictability, and it ensures that you’re making a profit each month and each year.
I always start from the bottom. Instead of leaving a profit to whatever’s left, I like to ask: How much do I want to make? And then I design all the parts around it so that I can get there.
Here’s what we did last year:
Our objective for 2018 was to hit a 15-20% profit margin. Why the variance? Because we knew we might want to re-invest a bit heavier in marketing. And that gave us a little window to play in. And everything is connected to that.
(As you’ll see below, this “window” isn’t a guess or a hope that we will hit that range.)
Profit for agencies is a simple equation if you really break it down into it’s simplest form:
Profit = Revenue – Cost of Goods Sold – Operating Expenses (all other expenses).
If you look at it as a pie, you start with 100%. Then, to make the margin you want, COGS and Operating Expenses both take up a % of the pie. What’s left over is your profit %.
Based on the market and our historical numbers, we know a 50% COGS is a reasonable amount. So, if we take 50% of the pie for that, we know we have another 50% to spend.
To maintain a 15-20% profit margin, that means we can spend another 30-35% on all other expenses.
Then, as long as we are maintaining a 50% COGS and 30-35% on all other expenses each month, we will hit our desired profit target. It’s really that simple.
Note: There are nuances such as utilization and other factors that you will have to account for to maintain the margins you want, but that’s outside the scope of this post.
Knowing your numbers and margins helps you make all sorts of decisions, such as:
– How much do I need to charge?
– How much can I pay employees or contractors?
– How much can I spend on marketing?
– What utilization do I need to maintain?
– Can I hire XYZ person?
And the list goes on…
Managing revenue and expenses:
At its most basic equation, the financial system is profits = revenue – expenses.
In order to hit your profit target, you need to understand what are the different revenue and expense streams.
Where does revenue come from?
Revenue comes from two different places:
First, it comes from the New Business System. When you close a client –whether that is for a one-time or recurring payment– you are growing your bottom line.
And the second channel is the Production System. Once your client has transitioned to the production team, you have four different ways to extract more revenue from them: upselling, cross-selling, extending the contract, and selling to another division/brand.
And where do expenses come from?
Expenses are generated by three systems –including the two mentioned above.
Expenses from the New Business System include everything you spent money on to close the client. Paid ads, your marketing team, networking events, conferences… they all go here.
The Production System expense is the Cost of Goods Sold. For example, if you run a web development agency, then web developers and designers. Aka, whoever does the project work, plus any tools that they need.
And finally, the Back-Office System. While the other two systems generate both revenue and expenses, the back-office is an expense center. But it’s also very necessary to run the business. It includes things such as rent, HR, accountants, lawyers, etc.
Managing your expenses.
Your revenue needs to be more than your expenses. And go ‘head, roll your eyes at me.
But here are the stats:
- 40% of small businesses are profitable. And I’m not saying they hit 6 or 7 figures, just “profitable.”
- 30% break even.
- And 30% are continuously losing money.
So it’s not such an obvious thing, is it? And your business won’t survive if you don’t manage your finances accordingly.
Be thoughtful about where you’re allocating funds month over month, and don’t spend money you don’t have. Keep track of financial indicators, and put effort into financial reporting and analysis.
I’ve Decided To Help Agency Owners Be Profitable
There are a couple of things that I’ve realized from running an agency for the last 7 years:
- Financial engineering, discipline, literacy, and understanding are critical when running an agency.
- No outside firm I’ve ever worked with understood my business well enough to provide the tailor-fit service that we needed. Either they didn’t truly understand the agency model, or they didn’t understand how important every dollar was to a small business owner like myself. And, typically, it was both.
We decided to manage our finances –including everything I touched on here– in-house.
Over time, I realized there were plenty of other agency owners that needed help on the financial side of things –and who better to help them than a fellow agency owner?
So, we decided to break out the part of Jakt that runs the financial system and turn it into its own company, servicing only agencies.
Polpo Finance is an Accounting + CFO service for Agencies that want to outsource their financial system and be more profitable and predictable.
If you are interested, email me at [email protected] and we can see if it makes sense to work together.
In conclusion of part 5: the financial system,
- The financial system is focused on the financial engineering needed to ensure you are making a profit each month and each year.
- Work backward from the profit margin that you want to hit. Then design the rest of the elements –pricing, expenses, etc.– so that you can reach that percentage.
- Expenses come from the New Business, the Production, and the Back-Office System. Revenue comes from the New Business and the Production System.