The golden rule of financial management

In financial management, there is a golden rule. It applies to all organisations, whether they are large or small, whether they sell products or services, and whether they operate in the public or private sectors. It’s not a complicated rule or even a very exciting one. But organisations ignore it at their peril. And those that do won’t be around for very long.

So what is this rule? Well, here it is:

“Turnover is vanity. Profit is sanity. But cash is king.”

So what does that mean for you and your organisation. Let’s look at each of the three elements of the rule in turn.

1. Turnover is vanity.

Turnover is the amount of income that the organisation generates by selling products, providing services or whatever else it does. Put another way, it’s the total amount of money you bill your customers.

A high turnover sounds very impressive. It’s great to be able to say at dinner parties that you’re the CEO of a company with a million pound turnover. But what does it tell us about how successful that organisation is? Ultimately, very little. Which is where the next part of the rule comes in.

2. Profit is sanity.

Profit is what you have left when you deduct from your turnover everything that it has cost you to generate it. It’s what you have left when you’ve paid all of the bills. As David Fishwick, star of the current Channel 4 programme ‘The Bank of Dave’ puts it, it’s the ‘bit in the middle’ that the organisation keeps for itself.

You might not call this ‘profit’ in your organisation. You might call it a ‘surplus’ or something like that, particularly if you are in the public or not-for-profit sector. But it’s still the ‘bit in the middle’, however you look at it.

Let’s take a company that does indeed have a turnover of a million pounds. Sounds great. But what if it has total costs (such as salaries, raw materials, buildings, printer cartridges, etc.) of one million and one pounds. To generate that million pounds of turnover costs the company one million and one pounds. So it has a profit of minus one pounds – it has made a loss. You don’t need to be Richard Branson to see that this is not good.

But take a second company. This one has a turnover of only one hundred thousand pounds. Straight off the bat, this looks like a less successful organisation, as its turnover is only one tenth of that of the first one. But this company has costs of ninety nine thousand nine hundred and ninety nine pounds. So it has a profit (positive this time!) of precisely one pound. This is clearly a much better position to be in.

We can see from this example that while a high turnover looks impressive, it is the profit that the organisation is able to generate from this that is more important. The bigger the organisation’s ‘bit in the middle’, the more successful it will be in the long term. And if it can’t generate a profit from its activities, then it needs to think very seriously about what it does and how it does it.

3. Cash is king.

Even highly profitable organisations can go out of business. And this is because no matter how large your ‘bit in the middle’ is, you can’t use it to pay your bills. For that, you need cash. So if all of your profit is tied up in offices, raw materials, finished products or outstanding debts from your customers, then you are going to run into difficulties when a bill comes in or when you need to pay your employees at the end of the month.

It’s not sufficient, therefore, just to generate a profit. You also need to turn it into cash. If you runs a retail business, then this may be quite easy, as your customers will pay you cash when they buy something from you. But if you have to send your customers an invoice and then wait for them to pay, or if you receive funding in instalments from somewhere, then you need to make sure that you always have enough cash on hand to pay the bills when they come in.

Clearly, you don’t want lots of cash sitting around doing nothing when you could be using it in your business. But you also don’t want to have your cheques bounce. So you will probably need to do a bit of planning to figure out when your cash will come in, when it needs to go out and whether there are any times when you are likely to run a little short.

You can then either try to get some of your cash in quicker (such as by reducing credit terms or billing long term clients more frequently), delay some of your outgoings (for example, by paying bills at the end of the payment period rather than as soon as you receive them or by negotiating payment in instalments for larger bills), or perhaps borrow some money from the bank (if you can) to cover the shortfall in the short term.

Whatever you do, don’t get caught out. Remember the golden rule: Turnover is vanity. Profit is sanity. But cash is king.

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