The E-Myth Chief Financial Officer: Why Most Small Businesses Run Out of Money and What to Do about It by Michael E. Gerber and Fred G. Parrish focuses on the importance of the chief financial officer role in a small business and how, in the absence of a full-time CFO, the entrepreneur must be willing to play the role.
It’s taken me well over a decade to truly appreciate the importance of how financial thinking permeates through every part of the business. This book was a timely read and extra motivation for me to pay greater attention to the systems we have in place, particularly the way we manage finances at Barrel.
Below are some highlighted themes from the book along with my thoughts on how they’ve applied to the creative services, website development, and digital marketing business that we run at Barrel.
The Role of the CFO
A key aspect of the CFO’s role is predicting which actions will give the company the best chance for success in the future. They must be able to identify the business drivers and the key elements that will produce the best outcomes. They should anticipate the effect of market conditions and have contingency plans sufficient to ensure optimal performance under any circumstance. They must understand what revenue mix and which staffing levels will produce the best margins. And they absolutely must know when cash issues will develop, the extent to which the company will be affected and what actions should be taken to mitigate the impact. Without this information, you are flying blind and any decisions are based on an educated guess at best.
…as CFO you must design metrics that fit each function in your company and will make sense to those people in product development, production, sales—in any area.
The key lesson here is that a good CFO has systems in place to help anticipate and plan for the future. One of the struggles we’ve had in running a small business is to get lost in the day-to-day only to be blindsided by cashflow challenges or creeping expenses.
As I’ve extricated myself from day-to-day client work for the most part, I’ve had more space to spend chunks of time examining our finances, testing out different metrics, and building out models to run best-case and worst-case scenarios. The benefit has been a greater sense of clarity in how the money flows through the business and a better understanding of why and how we made mistakes in the past so that we may avoid repeating them.
One metric that we never really examined until recently was gross margin. We finally got around to setting up a way to see more clearly our cost of goods sold (COGS) and from there, we’ve been able to benchmark the appropriate gross margin we should strive for each month. While this is a lagging indicator that won’t help us predict the future, it does help us assess the performance of a month and inform decisions we need to make on containing costs or increasing efficiency.
The other metric is utilization and getting a sense of how the team is tracking on billable hours on a given day, week, month, or quarter. We’ve been undisciplined about tracking time over the years, so it’ll be a bit of a transition as we set the conditions for tracking time properly. This way, we’ll have a greater degree of confidence in the accuracy of the data and get a clearer picture of how efficient we are in ensuring that our billable team members are working on client projects.
The Four Kinds of Money
I like how Gerber and Parrish break down business money into four distinct types:
Income is the money business owners are paid by their company for doing their job in the company. It’s what they get paid for going to work every day.
Profit is what’s left over after a company has done its job effectively and efficiently. If there is no profit, the company is doing something wrong.
Flow is what money does in a company, as opposed to what money is.
- The First Rule of Flow states that your income statement is static, while the flow is dynamic. Your income statement is a snapshot, while the flow is a moving picture. So, while your income statement is an excellent tool for analyzing your company after the fact, it’s a poor tool for managing it in the heat of the moment.
- The Second Rule of Flow states that money seldom moves as you expect it to. But you do have the power to change that, provided you understand the two primary sources of money as it comes in and goes out of your company.
Equity is the financial value placed on your company by a prospective buyer.
- The value of your equity is directly proportional to how well your company works. And how well your company works is directly proportional to the effectiveness of the systems you have put into place upon which the operation of your company depends.
My takeaway from this breakdown was that we may have spent too much time for most of Barrel’s existence trying to generate income and navigate flow while not doing enough to build the systems that would ultimately make the business more profitable and valuable.
Luckily, I think we’ve started heading in the right direction, and while I’m sad that there were some lost years, it’s better late than never to start truly building up the value of my equity.
Cash is King
In working through numerous difficult situations with these business owners I have also learned the hard lesson that you cannot truly understand the implications of a certain set of circumstances without living through them. Managing a severe cash flow problem is at the top of that list. You may be able to understand it from an intellectual perspective or possibly even have an idea about the stress that is associated. But unless you have a direct and personal experience in that environment you have no idea what it’s like.
Preserving or increasing cash should be the foundation on which all decisions are made. If you have sufficient cash, you can weather any storm and will have the resources to support the associated operating requirements of any level of growth.
Cash is the Lifeblood of Business: Cash flow problems are to blame for 82 percent of business failures. Although profits are defined as “a valuable return,” the reality is that you cannot actually “spend” profits, so you must have sufficient cash available to fund the company’s operations until profits can be converted to cash. Since there is nothing tangible returned by profit alone, the logical conclusion is without cash conversion there is no REAL profit; therefore, it would follow that cash flow is the true profit indicator.
Profitability and Cash Flow are Inextricably Linked: You must have profits to produce cash and you must have cash to produce profits. The cycle cannot be broken indefinitely without seriously negative results.
I’ve pulled out the four paragraphs above because the authors’ emphasis on cash management couldn’t ring truer with our own experience. We’ve seen and felt it all:
- A large stockpile of cash burned in a blink of an eye when we hit a rough patch with landing new business one quarter.
- The handiness of our line of credit in critical moments when we’ve had delinquent client payments.
- The baller feeling of putting away large chunks of cash into our “vault” for a rainy day which we felt would never come and then the crappy feeling of drawing down on the vault when said rainy day actually came.
- The emergency 11th hour partner injection of cash (from selling investments) in order to make payroll only to see a last second barrage of client checks come in on the same day.
“Preserving or increasing cash should be the foundation on which all decisions are made.” – amen.
Profitability is a Team Effort
You must understand that you cannot control the company’s profit from your office or your boardroom. It requires the efforts of everyone in the company. Each person in the business can make hundreds of decisions every day. Some are larger, more important and deliberate steps, but most are smaller seemingly incidental actions. However, the cumulative effect of all those decisions day by day, week by week, month by month over the years will define your company—good or bad.
Not only should each staff member be trained in every part of their jobs, there must be effective communication between the different functions in the business. It is crucial that each employee understand their role as it relates to others in the company. They should be clear about the effect of their actions both upstream and downstream from the function they perform and how they can contribute to the success of the company. Defining the correct systems will ensure this communication is appropriate.
The paragraphs above hark back to a recurring theme that’s continued to stare me right in the face: it’s all about having the right systems in place.
We’ve seen this unfold as we’ve worked to put in a number of new systems in how we handle business development, project management, resourcing, talent acquisition, and account management. There have been incremental gains as well as learnings that have sent us back to the drawing board. I don’t think we’ll ever be fully satisfied with the systems we have in place, but what matters is that we continue to improve and refine.
What I need to remind myself as we do this is to make sure the team at large has a clear understanding of what we’re trying to do and how our systems work impacts the business. In my mind, the work we’re doing on systems may make a lot of sense, but to an employee in a junior role without much context, the workplace may look like an arbitrarily changing environment. I hope we can avoid this.
A Structured Way to Grow
What are the keys to growing?
- Deciding how much growth you want for your company.
- Creating a detailed plan for achieving that growth.
- Quantifying those details and setting specific targets for the key areas of the business.
- Constantly communicating those goals to your managers and working out the details for success.
- Putting reporting structures in place, including those for identifying and managing business drivers and metrics, along with compensation systems to help align priorities and incentives for your mid-level and senior managers.
- Regularly evaluating your progress, adjusting the plan and repeating the process.
Growth is not the same as headcount, although for a long time I confused increase in headcount with growth. Back in 2013, we had a similar number of full-time employees as we do now but at perhaps half the salary load (younger, cheaper talent) with little to no structure in the org and generating a lot less in revenue.
These days, growth has many dimensions for us. There’s top-line revenue growth, which may be due to larger accounts, more clients, or both. There’s bottom-line profit growth, which could be due to greater efficiencies, better pricing, and higher-margin services. And there are other forms of growth, like our ability to offer a greater range of services or for us to go deeper into a particular area of focus.
While the book focuses primarily on financial growth from the CFO’s perspective, I do appreciate the first step of actually thinking through and deciding the type of growth you want for the business. This type of intention-setting helps to set priorities and provides a sense of control in setting the trajectory of the business.
Strategic Work vs. Tactical Work
Small business owners are doing strategic work when they ask the following questions:
– Why am I a small business owner?
– What will my company look like when it’s done?
– What must my company look, act, and feel like in order for it to compete successfully?
– What are the key indicators of my company?
Small business owners who commonly ask strategic questions know that once they ask such a question, they’re already on their way to envisioning the answer. Question and answer are part of a whole. You can’t find the right answer until you’ve asked the right question.
Tactical Work is much easier, because the question is always more obvious. In fact, you don’t ask the tactical question; instead, the question arises from a result you need to get or a problem you need to solve. Billing a client is Tactical Work. Advising a client is Tactical Work. Firing an employee is Tactical Work. Conducting a property analysis is Tactical Work. Tactical Work is the stuff you do every day in your company. Strategic Work is the stuff you plan to do to create an exceptional company/business/enterprise.
This has been and, on many days, continues to be, some of the most challenging aspects of my day-to-day: the tug-of-war between spending time on Strategic Work vs. Tactical Work.
Tactical Work is addictive. Oftentimes, the feedback is immediate and there is a dopamine hit every time I’m able to quickly solve a client issue or to point employees in the right direction. This extends to my work on new business where having good rapport on a call with a prospect or knocking out a proposal feels like progress.
Strategic Work, on the other hand, requires space and focus. It’s easy to get frustrated because it’s tough to know whether your decisions will be right or wrong until some time has passed. The deliverables are also not as clear-cut.
However, there’s a non-linear aspect of Strategic Work that is really powerful. Setting the right intentions for the organization, making the high-level decisions, and bringing the big picture into focus for the team–these actions can quickly scale and amplify in a manner that no amount of Tactical Work on your own possibly can.
I found this book helpful because it was yet another reminder for me to take a step back, ask some hard questions about the business (Strategic Work), and focus my time on examining and building out systems. It’s so easy to get sucked into troubleshooting mode and coast through the day-to-day routine of inboxing to zero and crossing off tactical to-do’s. I’ve come to dread weeks when my calendar is full of 30-minute calls and 1-hour meetings where I know my attention will be pretty scattered and what feels like a bunch of productive conversations in the moment will ultimately be fillers with low nutritional value for the organization.
In some respects, I’ve often wondered if I can be of greater value to the business if I worked less hours (or even days), minded the day-to-day even less, and put in perhaps a half dozen 3-hour Strategic Work sprints each week. How much more progress would we make then? Something to continue thinking about and maybe even putting to the test.
Absolutely awesome detailed article