The seven levers that move profit and cash

There are only seven things you can change in a trading business. You can charge more, sell more, pay less for what you sell, spend less on running the place, get paid faster, hold less stock, or pay your suppliers later. Everything else is a way of doing one of those.

That is a useful thing to know, because it means the question is never what to do. It is which one, and by how much, and what it is worth when you get there. Most owners have a strong instinct about the answer and most of those instincts are wrong in the same direction: they reach for volume, which is the second weakest lever they have.

This guide works all seven on one business, with the same figures the calculators use, so you can open either tool and follow along without typing anything in. It also does something the standard version of this does not, which is read each lever the way a credit team reads it. Four of the seven move what a business can borrow. Three of them move it by nothing at all, no matter how much cash they release, and knowing which is which will save somebody a wasted quarter.

One business, seven levers, one per cent each

The business below turns over $4.2m. Cost of sales runs at 58%, so gross profit is $1,764,000. Overheads take $1,320,000 of that, leaving an operating profit of $444,000, which is a margin of about 10.6%. Customers take 52 days to pay, stock sits for 41 days, and suppliers get paid in 38.

It is a perfectly ordinary business. Nothing is broken and nothing is remarkable. Now move each of the seven by one per cent, or by one day, and see what each is worth on its own.

Three things in that table are worth stopping on. Price is worth two and a half times what volume is worth at the same percentage. The three days levers produce real cash and move borrowing capacity by nothing. And one per cent on all seven at once adds $97,200 to a $444,000 profit, which is a 21.9% increase from seven changes nobody in the business would notice individually.

1. Price

A one per cent price rise on $4.2m of revenue puts $42,000 on the bottom line. All of it. Nothing about producing the goods changed, nobody had to be hired, no extra stock was bought. The whole rise falls through.

That is the entire reason price beats everything else, and the size of the gap is not a matter of opinion. It is your gross margin. This business keeps 42 cents in every dollar, so a dollar of price is worth the same as $2.38 of sales. Sell at a 25% margin and a dollar of price is worth four dollars of sales.

How much volume you can afford to lose

The objection to a price rise is always the same and it is a fair one: customers will leave. So work out how many can leave before you are worse off. At a 42% margin, a one per cent rise can lose you 2.3% of your volume and leave you exactly where you started. A two per cent rise can lose 4.5%. A five per cent rise can lose 10.6%.

That is not a prediction about your customers. It is the width of the ledge you are standing on, and most owners assume it is far narrower than it is. If you put prices up two per cent and lost one customer in fifty, you would be ahead.

How a lender reads it

A price rise that holds is the strongest thing a set of accounts can show, because it is evidence of something a credit team cannot otherwise test: that the business is not the cheapest option and does not need to be. Margin improving while revenue holds reads as pricing power. It is the pattern that gets a file through with the least argument.

The version that reads badly is a price rise followed by falling revenue and a flat margin, which says the market did not wear it and the business discounted its way back. That is why the sequence matters more than the size. A rise you can hold for four quarters is worth more in a lending file than a larger one you had to walk back.

2. Volume

Selling one per cent more is worth $17,640 of profit, against $42,000 for charging one per cent more. The difference is that the extra sales arrive carrying the cost of producing them. You keep the margin, not the revenue.

That is the well-known half. The half that catches people is what growth does to cash.

The growth trap

This business carries $598,356 of debtors, $273,633 of stock and $253,611 of creditors. Net, about $618,000 of working capital is tied up in trading at its current size. Grow by ten per cent and that working capital grows too, because more sales means more invoices outstanding and more stock on the floor before any of it turns into money.

A third of the profit from growth never reaches the bank in the year you earn it. And that table assumes the days hold. In practice a business growing quickly collects more slowly, because invoicing falls behind and nobody is chasing, so the absorption is usually worse than this.

This is how a genuinely profitable business runs out of money. Not through losses. Through growth funded out of the trading account, where every new customer takes cash out for two months before putting any back.

How a lender reads it

Growth improves borrowing capacity, because capacity follows earnings and earnings went up. What it can do at the same time is worsen the position that gets you the money. Rapid growth with stretching debtor days and a drawn overdraft is a recognisable and unwelcome pattern in a credit file, and it looks the same whether the underlying business is excellent or in trouble.

The practical point: if you are planning to grow and to borrow, the borrowing conversation comes first, while the numbers still look calm. A facility arranged before a growth year is a different conversation to one arranged three quarters into it.

3. Cost of sales

Cost of sales is $2,436,000 here, so one per cent of it is $24,360, and unlike the price and volume levers it arrives as profit and cash in the same period. Nothing is waiting on a customer to pay.

It also sits second on the list, ahead of overheads, for a reason worth internalising: cost of sales is usually the largest number in the business after revenue. A percentage of a big number beats a percentage of a small one, and most cost-cutting attention goes to the small one because it is easier to look at.

Where to look before you start negotiating

The ATO publishes what businesses in about a hundred industries actually spend, drawn from real tax returns rather than from a survey. If your cost of sales runs at 58% and the published range for your industry and turnover band is 48% to 54%, that is ten percentage points of gross margin sitting somewhere, and it is a far better place to start than a general instruction to squeeze suppliers.

It also works the other way, and this is the more common outcome. If you sit inside the range, the cost of sales lever is probably not where your next $100,000 is, and you have just saved yourself a quarter of arguing with suppliers about it.

How a lender reads it

A gross margin that improves and stays improved is read almost as well as a price rise, and often it is a price rise wearing different clothes. What gets tested is whether it holds. A single good year on cost of sales, with two ordinary years behind it, gets treated as a good year rather than as a new level.

The one to be careful with is a margin that improves because the business took on lower-cost, lower-quality supply. That shows up eventually as warranty, rework or lost customers, and a credit team that has seen it before will ask what changed rather than congratulate you.

4. Overheads

Overheads are $1,320,000, so one per cent is $13,200. It is the smallest of the four earnings levers in this business and it is the one most owners reach for first, because it is the only one that does not involve talking to a customer or a supplier.

That does not make it worthless. It makes it the wrong place to start. If you need $250,000 of additional profit, you would need to take 18.9% out of overheads to get there on that lever alone, against 5.9% on price. One of those is a difficult conversation and the other is a restructure.

The one per cent overhead review

The version of this that works is not an annual cost-cutting exercise, which tends to remove things the business needed and then quietly buy them back. It is a standing review of one line a month. Twelve lines a year, each looked at properly once, is more effective than all of them looked at badly in one week every February.

We do not provide audit or assurance services and this is not one. It is a business owner reading their own general ledger with a specific question in mind: what is this for, who decided, and would we buy it again today at this price.

How a lender reads it

Here is the part nobody tells owners. A credit team going through your overheads is doing two things at once. The first is assessing the cost base. The second is looking for costs that are really the owner's lifestyle, because those are add-backs, and add-backs raise the earnings the facility gets sized on.

So an overhead line that is genuinely discretionary and genuinely personal is not a weakness in a lending file. It is worth more to you identified, evidenced and added back than it is quietly removed a month before you apply, because a removed cost is a cost the accounts no longer explain. Every add-back needs paperwork behind it, and the line most often rejected is the one where the owner says it will not repeat and cannot show why not.

5. Debtor days

Now the three that behave completely differently. Collecting one day faster releases $11,507 in this business. Seven days faster releases $80,548. That is real money and it lands in the account.

It is also a one-off. Getting from 52 days to 45 releases seven days of revenue once. The following year, at 45 days, releases nothing further. The business is permanently better off by $80,548 and it does not receive $80,548 again.

Why the profit and capacity columns are empty

Collecting faster does not change what the business earns. The sale was made, the margin was made, the profit was already in the accounts. What changed is when the money arrived, and a lender lends against earnings rather than against timing.

This matters because the instinct is exactly backwards. Owners who need a bigger facility very often go and work on debtor days, on the reasonable assumption that more cash means more borrowing capacity. It does not. Capacity moves when profit moves. Everything in the bottom three rows of that first table moves cash and moves capacity by nothing.

How a lender reads it

The debtor book is read closely, and not for its size. What gets attention is the ageing profile and the concentration. A ledger where most of the balance sits inside terms reads as a business with systems. A ledger with a long tail beyond 90 days reads as a business that does not chase, and the amount beyond 90 days usually gets discounted out of the security position entirely.

Concentration is read separately and harder. One customer at forty per cent of the ledger is a different risk to forty customers at one per cent each, whatever the total says.

Invoice finance against fixing the ledger

There is a facility that turns your debtor book into cash today, and it is a legitimate tool. It is also frequently used to avoid a conversation about collections that would have been cheaper. An invoice facility quoted at eight per cent rarely costs eight per cent once the line fee, the service fee and the unused portion are counted, and the number that matters is what you paid divided by what you actually drew.

The order we would suggest is: work out what the ledger would release if it were run properly, work out what the facility genuinely costs, and then decide. Both are arithmetic and both take an afternoon. Where a client wants a facility arranged, that is a referral to The Lending Lab Pty Ltd, a separate broking business, disclosed in writing at engagement.

6. Stock and work in progress

One day less stock releases $6,674 here, and seven days releases $46,718. Smaller than the debtor lever, because stock is costed at what you paid rather than what you sell it for.

The reason this one goes unexamined for years is that it does not appear anywhere a business owner routinely looks. It is not on the profit and loss. It does not show up as a payment. It sits in a shed, or on a server as unbilled work in progress, and the only sign of it is a bank balance that never quite matches how the year felt.

For a service business the same money is buried in work in progress: jobs done and not yet invoiced. It behaves identically and it is usually worse, because at least the stock in the shed is visible when you walk past it.

How a lender reads it

Stock is read sceptically, and the question is always how much of it would actually sell. Slow-moving and obsolete stock carries a real cost in a lending file, because it inflates the balance sheet without supporting anything. A business that writes down dead stock will usually present better than one carrying it at cost, even though the write-down reduces the reported result.

Work in progress is read harder still, because it is the line most easily used to make a year look better than it was. Expect to be asked how it is measured and what it turns into.

7. Creditor days

Taking one day longer to pay suppliers releases $6,674, and seven days releases $46,718. The arithmetic is the same as the stock lever, and it is the only one of the seven where the improvement costs you nothing to make and can cost you a great deal to get wrong.

Stretching payables is real working capital and it is also the fastest way to lose a supplier relationship you spent years building. Suppliers talk to each other, and the ones who matter to you are the ones who can hurt you when they stop extending terms.

There is a version of this that is entirely legitimate: paying on the terms you actually agreed rather than early out of habit. A surprising number of businesses pay 30-day invoices in seven days because that is how the run has always been set. Moving to the agreed terms costs nothing and offends nobody.

How a lender reads it

Creditor days are one of the most closely read numbers in a file, and unlike the others, the wrong direction is unmistakable. A creditor balance that is stretching while revenue is flat says the business is funding itself from its suppliers, which is the cheapest and most dangerous credit available, because it can be withdrawn without notice and usually is at the worst moment.

ATO debt sits in the same category and is read more harshly still, because a payment arrangement is a matter of record. If there is one, it belongs in the conversation early and with the arrangement attached, rather than discovered.

Why one per cent on all seven beats five on any one

This is the part that changes what people actually do. Take the business above and say it needs $250,000 more profit. Here is what each lever would have to do on its own.

Two and a half per cent on four things, against six per cent on one. The same destination, and nobody in the business has to be told that this is the year everything changes.

This is why the framework is built the way it is. Not because small changes are somehow more virtuous, but because four small changes compound into the same number as one large one and each of them is individually survivable. A five per cent price rise is a decision with a risk attached. Two and a half per cent on price, on volume, on cost of sales and on overheads is four ordinary quarters.

Which one to do first

In rough order, and with the obvious caveat that your business is not the one in the table.

• Price, always, because it is worth the most and costs the least to try. Start with the customers you would be least sorry to lose.
• Cost of sales, because it is the largest number after revenue, and because the published industry ranges will tell you in an afternoon whether there is anything there.
• The three days levers, if the problem you actually have is cash rather than profit. They will not move what you can borrow and they will change what is in the account next month.
• Volume, once the first three are done, because growth multiplies whatever margin you have. Growing a thin margin quickly is how businesses get into trouble that looks like success.
• Overheads, continuously and one line a month, rather than in an annual exercise that removes things you needed.

And if the answer you need is a number rather than a direction, work it backwards instead. Name the profit, the margin or the facility you want to be able to carry, and read what each lever would have to do to get there.

The words, briefly

What we can and cannot tell you

Andorra Advisory Group does not arrange credit and is not a credit representative. We build the analysis and the documents. Where a client wants the finance arranged as well, that is a referral to The Lending Lab Pty Ltd, a separate broking business, disclosed in writing at engagement. Our fee is fixed and payable regardless of whether finance is approved or what the analysis concludes.

So no lender is named here and no policy is quoted. The borrowing capacity column throughout assumes 1.5 times cover, a 9% assessment rate and a seven year term, and it is on the screen for that reason rather than hidden behind a single figure. Every lender sets its own criteria and the same earnings support very different facilities across ordinary settings. We give no taxation advice, no legal advice and no financial product advice, and we provide no audit or assurance services.

The one input none of this supplies is what your market will bear. The arithmetic tells you what a price rise is worth and how much volume it could afford to lose. It cannot tell you whether your customers would go, and that is the question the whole first lever turns on. What it can do is show you the size of the ledge before you decide.

General information only. Not credit advice, not a credit assessment, and not an offer of finance. Lending decisions rest with the lender and depend on your circumstances and their criteria.