By Miles Stover
Every company — no matter what segment of the cannabis industry, and no matter what level of profitability or lack of profitability the company is experiencing – should always be looking for money. Even if you are making money so fast you don’t know what to do with it, keep looking for more money at the right price. This column will discuss what the people with money want to talk about and how to talk their talk.
The bottom line is that by computing a few ratios, you will know exactly how you rate against your competition. You will know exactly where you need to improve to improve your chances of attracting capital at the right price.
The following discussion of some basic formulas will tell you a lot about how to run your business, but more importantly, will also make you learn about the accounting tools that you will need down the road.
There are really only two types of investors — financial and strategic. Financial investors look at the bottom line to see if you meet their investment criteria (there are specific ratios they will look at). Strategic investors invest in companies where they can get some “value added” such as getting into a niche they want to get into fast, get a relationship the investor never has been able to get before or get something that complements their other operations. They will look at different ratios.
Regardless of the type of company investors are looking at, they all look at certain financial indicators. The simplest indicator to calculate is the break-even point (BEP). It is very easy to compute and is a good start to understanding the other indicators investors will look at.
The break-even point is where your products stop costing you money to produce and sell, and start to generate a bottom-line profit for your company (and ultimately an investor). Let’s do a very simple break-even point analysis.
1. Determine the per-unit selling price and the direct costs.
Let’s say you sell cannabis by the gram. In this example, the “direct cost” of the material is $10 per gram.
2. Calculate your contribution margin per unit.
Let’s say you sell cannabis for $18 per gram. The “contribution margin” (CM) is the amount you get above the direct cost of each unit you sell. This is the amount you contribute toward the overhead costs.
3. Calculate your overhead costs.
Overhead (OH) is made up of the expenses you incur in your business that need to be covered before you start to earn a bottom-line profit. Typical costs are insurance, labor, rent, taxes, advertising, office supplies and utilities. These are calculated in total dollars and not on a per unit basis.
4. Determine your break-even point.
Once you know your overhead costs, take that amount and divide it by your contribution margin in dollars per unit. Example: Let’s say your overhead is $1,000 and your contribution margin is $8 per unit. Your break-even point in units is (OH/CM = BEP) or $1,000/$8 or 125 grams. Simple! Now let’s see why this is a good starting place to do financial forecasting.
Let’s say you are able to cut overhead costs to $800 in the example above. Your break-even point goes down to 100 grams. Then, let’s say you raise your selling price $2 per gram, bringing your contribution margin to $10. Your break-even point goes down to 80 grams. Investors will want to see these relationships so they can play “their games” — if they can do things less expensively than you can, they know your break-even point will also go down, resulting in more profits.
Let’s complicate things just a little. Don’t panic — this knowledge will help you as well as a potential investor.
Overhead costs are made up of variable and fixed costs. We need to divide them for a better understanding and to produce a forecasted net profit.
Fixed costs (FC) are any costs that do not go up or down based on volume/revenue. For example, rent will be the same if you sell 100 grams or 1,000 grams of cannabis. Insurance will be the same for the building regardless of the revenue levels. Vehicle lease payments, dues and property taxes are examples of fixed costs.
Variable costs (VC) fluctuate based upon activity. Taxes on sales, transportation costs, supplies and packaging materials are examples. We are keeping things real simple now acknowledging that some costs have a variable and fixed element to them.
5. Set up a spreadsheet with these BEP formulas so “what if” scenarios can be considered.
Let’s make the BEP a financial management tool for you and potential investors. To get a feel for how this tool can be used let’s ask some questions:
- If we can reduce overhead by $10 how many less units do we need to sell to break even?
- If we raise the selling price by $1 and units sold go down 10 percent, what happens to the break-even point?
- If we raise the price by $.50, but it takes an increase of $100 in overhead, what happens?
- If competition suggests we lower the selling price by $1 how many more units need to be sold to break even?
- What if the price we have to pay for material goes up $1 per unit and overhead goes up $120 due to security issues and we add one employee at $3, but terminate a now former employee at $4 OH? What is the BEP?
Using an electronic spreadsheet allows the various “what if” scenarios to be played out easily. An Internet search of “How to compute a break-even point” will show you multiple other ways to compute BEP based upon your individual information.
The easiest and best way to set up an income statement spreadsheet for BEP and the formulas used by investors is to take your income statement below the Revenue section and set up five columns as shown below. This makes it easy to drop in budgeted amounts or actual results to get the management information you need.
Once you get a feel for what you are trying to accomplish, the list of expense categories grows on your spreadsheet but the premise stays simple. (Jumping the gun a little — if you go to the Risk Management Association books for your specific SIC Code and/or NAICS Code you can put your spreadsheet together in the exact same format as they use so you will know exactly how you compare instantly. The Risk Management Association Statement Studies collection of books — formerly known as the Robert Morris Associates Company Statement Analysis — tells you what every banker looks at to compare your financial ratios and success against your specific competitors. Investors use the same analysis because it is so comprehensive and unbiased, while maybe using a few different ratios than a banker might.)
In this short article we have learned that there are ratios and statistics that you will eventually be forced to face to run your business more efficiently and/or to attract investors. Knowledge of the ratios that will be used by your competitors and investors is valuable. Knowing certain ratios also tells you if you are performing at an acceptable level against your competitors. Knowing that accounting is not to be feared and truly is the common language of business should make you more receptive to doing simple ratio analysis on a consistent basis.
The real bottom line is that you are in business to make a profit. The more you know about how to do it, the better.
In future articles, we will discuss sophisticated ways to attract investors, how to make presentations on the subjects they care about and the accounting issues they are concerned about. If you are looking for funding, you need to know the language of business. Unfortunately for those of you that do not like accounting or even thinking about accounting — you need to change your attitude. Accounting is the language of business.
These articles will not be about accounting, per se. They will be about how accounting and ratio analysis can tell you if your business is in trouble, whether you are under-performing or performing better than your competition, and also about how to use accounting to tell a story that will attract investment.
Knowing accounting can also tell investors you know how to get out of the trouble you are in, or how you are doing so well and why they should invest in you. Many of the questions you will be asked on your fundraising adventure are standard and we will talk about them. In fact, most questions you will be asked will relate to how you stack up against your competition.
Miles Stover is the founder and president of Turnaround, Inc. and TurnRight, Inc. For more than three decades, he has worked hands-on with organizations from start-ups to Fortune 100 companies in a variety of roles.