Business IQ vs. EQ: Part 1 – Income vs. Expenses

At its core, there are only two factors that determine the success of failure of a business.  Its income and its expenses. If the income is higher than the expenses, the business will (at very least) survive. If the expenses are perpetually higher than the incomes, it will ultimately fail. The longer funds are borrowed to cover the shortfall, the more spectacular the failure can be so beware!

This brings us to the first fundamental EQ question. Will this business eventually make more money than it consumes and will it be enough and early enough, to make it worthwhile? Of course, financial analyses can help with this question, but these forecasts are based on assumptions and are thus never accurate.

Incomes are generally easy to ascertain. Just look at the invoices going out. They will tell the story of the amount of sales of each product or service, the seasonality of the business and the relative size of projects or the value of each sale (i.e. few sales of a high value item or many low value item sales). Income recovery rates will factor into the actual cash flow of the company which may be a concern if it is highly seasonal. However, unless some of the invoices are not paid or the interest rate for bridging finance is excessive, ongoing businesses should not have problem as long as average incomes are higher than average expenses. Other incomes include interest and dividends a business might get from investments (in a bank, market or other businesses). These may be higher than invoiced services or products, depending on the type of business.

The expenses are somewhat more complicated. They are generally split into fixed- and variable expenses. Fixed expenses recur regardless of the amount of production and sales. Variable expenses increase linearly (i.e. in proportion to the increase/decrease) as the production (and hopefully sales) changes. Examples of fixed expenses are salaries to management and administration and payment for fixed assets though it should be noted that even these need to vary if production increases or decreases drastically. Variable expenses go towards things like raw materials, storage- and transport costs, services, salaries to employees and consumables.

At this point it is worth noting that a mark-up on a product or service often doesn’t include all of the fixed costs. Thus, the margins often sound much more generous than they are. This depends on the ratio of fixed and variable costs and how much of the margin needs to go towards covering fixed costs.

You will already have noted that simply sticking to the numbers, even on this, the most basic level in a business, could require a fair amount of complication. That said, very few business owners have their finger on the IQ pulse enough to be able to work of these numbers. Instead, they’ll worry about the size of margin on products and services and how much they need to sell based on gut instinct and years of experience. They’ll let the accountants give them the final numbers at the end of the financial year. If you are evaluating a business and don’t have the experience in that industry, reverting back to crunching the numbers may be your only option… if you can get hold of the raw data.

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