Why the ‘Power of One’ is the best tool to fix cash flow in your business
Did you know that a 1% adjustment on three levers in your business could increase your net profit by 19%? Yes – you read that correctly. 19%! Just think of the effect this could have on cash flow in your business. It could be the difference between surviving and thriving in the aftermath of COVID.
Cash flow problems are an epidemic in themselves. The last year has been incredibly challenging. Many companies have experienced substantial revenue loss from being shut down for weeks or even months. The businesses that have thrived are those with a ready supply of cash. This has acted as a buffer and allowed for lucrative pivots as the market changes.
And it’s not over yet. As we emerge, bruised and battered from a brutal cycle of lockdowns, we’re seeing a tangible sense of nervousness in our clients. People think there’s a fragility to the recovery. This is compounded by increasing difficulty hiring staff. Salaries are increasing and it’s hitting cash flow at precisely the worst time. Don’t bury your head in the sand and hope it will improve. It won’t. Inflated salaries are here to stay. So, you need to find other ways of increasing cash flow to maintain your pre-pandemic margins.
In last week’s blog, we took a deep dive into the flow of cash through a company, exploring ideas and methods for improvement. But here, I’d like to introduce you to a nifty tool that every company should use. It will tell you what approach to take and which levers to pull. It’s called the ‘Power Of One’.
What is the ‘Power of One’?
The Power of One was devised by a South African guy called Alan Miltz. The co-author of the chapter on cash in ‘Scaling Up’, he’s become a global thought leader in financial analysis for businesses, banks and accountants. His techniques are used in more than forty countries around the world by over 20,000 customers. His message is simple. ‘Revenue is Vanity. Profit is Sanity. Cash is King’.
Alan identified that small, incremental changes can have a massive impact on cash. But often people have a hard time understanding this. They can’t see the size of the potential impact. The default when looking to improve profit is often to reduce the cost base. But overhead expense is only one of a number of levers that can be pulled. And sometimes it’s knowing which has the biggest effect that’s missing from people’s understanding.
To plug this comprehension gap, Miltz designed a software tool that we use all the time with our clients. Available on subscription from his website cashflowstory.com, it’s transformational. By running 10 to 15 numbers from the client’s business through the software, it shows how small adjustments can result in huge improvements. These are fascinating insights that lead to strategic game-changers for our clients.
Your 7 cash levers
So instead of defaulting to a mindset of cost-reduction, what are the other areas you should be considering? Alan identified 7 levers that can powerfully affect profit, cash flow and business value. They are:
3. Cost of goods sold
5. Accounts receivable days
6. Inventory/work in progress
7. Accounts payable days
With the ‘Power of One’, we get the Executive Team together to ask, ‘What happens if we put the price up by 1%?’ Or, ‘How about if we increase the volume by 1%?’ Maybe we try changing accounts receivable by one day. Or experiment with paying a day later. As we work our way through the different scenarios, we play with the numbers using the software tool and see what happens. What’s the impact and what’s the effect?
And here’s what we’ve learned. If you increase sales by 1% and decrease the cost of goods sold and operational expenses by 1%, it will result in that magical 19% uplift in cash. Phenomenal!
Increasing prices has the biggest effect
The other major take-home from this work is the impact of increasing your prices. Of all the levers, this has by far the biggest effect on cash flow. And yet we hit so much resistance when we suggest it!
The knee-jerk reaction tends to go something like this. ‘We can’t put the price up. Sales will complain! The customers will complain! We’ll lose business.’ With one of our clients, we eventually persuaded them to try an increase of 1% per month. That was two years ago and they’ve continued with no detrimental effect on their business. The result? A massive uplift in margin of 35%!
We were with a client only last week who’d raised their prices 2.5% last year and, emboldened by their success, have decided on a 10% increase this year.
You need to overcome the fear of rising prices and the conniption it causes. Because it’s all in your head. Maybe it’s linked to a distorted sense of self-worth. Or a terror around losing customers – I get that. You’re likely to be feeling it even more in the current environment. But I’ve never worked with a client where there’s been elasticity and volume has fallen due to price increases. Never.
Band prices in ‘threes’
Have you ever noticed that restaurants tend to band their wine list into three – cheaper, medium-priced, expensive? The majority of their sales will be in the middle. It’s all about perception. Customers perceive the best value to be had in the middle of the price range. This can be manipulated to increase profits – with higher mark-up wines deliberately placed in the mid-price bracket to increase margin on wine sales.
It’s common practice – you see it when you look at airline tickets. If you get on a flight, it’s likely that not a single person is paying the same rate. But people don’t walk off the plane in protest! For every Loganair route, customers are given three prices. Again, the volume will be in the middle of the price banding and you’ll find even if the prices on either side increase, the gravitational pull of the centre will continue. These tricks of the trade could have a major strategic impact on your profits. Have a listen to our Melting Pot podcast interview with Hermann Simon, author of ‘Confessions Of A Pricing Man’. It’s illuminating!
Planning for exit
The Power of One works brilliantly if you’re planning for exit. You’ll have a goal for EBITDA (meaning Earnings Before Interest, Taxes, Depreciation and Amortisation) to reach a certain value because you think you can get 10x this goal in the final sale. So, use the Power Of One as a future planning tool. What do you think your volumes and prices will look like three years from now? Where do they need to be? This tool will enable you to map out your journey and final destination with real clarity.