I know that you are really good in your field. Design, development or anything you do, I know that it is good, and you’re always trying to get better and earn a higher paycheck.
Well, you know, you don’t have to be a finance expert, but money management is really important since if you don’t do it, it doesn’t matter how much you make, you’ll never have enough for tomorrow.
This is why we will be talking about money management. We’ll see 4 important tips and some concepts that will help you in your life about things that are even against common sense (like “Profit is not that important”).
So, let’s rock!
Prevent bankruptcy, always keep track of your cash flow (and forget about profit)
Let’s start with 2 basic definitions:
- Cash flow – all money movement that happens, be it income or expense. So, every time the amount you have in your bank account changes it is cash flow happening.
- Profit - sales less expenses. When you close sales you have profit, and when you order things you have financial loss (just loss, from now on).
You may be asking yourself now, why is this so important? This is because you must pay attention to your cash flow all the time, but you don’t have to make a profit all the time. I mean, if you always care about positive cash flow and cash flow management you’ll prevent bankruptcy and maybe you’ll never have loss, but if you just look at your profit you have a much higher risk of losing out on seeing the big picture and going broke.
Let’s say you close a deal for $10,000 to be paid 50% in advance and 50% upon completion. Your production costs are $7,000 but you have to pay it in advance. In this case you’ll have a negative cash flow of $2,000 at the beginning of the project ($7,000 paid but only $5,000 received) and your positive cash flow will occur when you receive the last $5,000 – by this time you’ll have both cash flow and profit of $3,000 (total of $10,000 – $7,000).
Hot money – Sounds good but tastes bad
Can you see how dangerous this scenario is? When you have negative cash flow you have to get what we call “hot money”. This kind of money is very expensive, so we pay high interest rates to get it for a few days only (credit cards, for example). And this money is used to fix the mess caused by negative cash flow (like paying suppliers). So in this example you’ll have to get $2,000 from nowhere and pay for it. You have profit but negative cash flow (in beginning).
Also you can experience deals with welcher clients. This is why it’s so important to collect a deposit for design work. This is especially dangerous for freelancers, because you usually have a low amount of profit from each sale, so you’ll have to work much more in order to compensate non-paid debts or high interest rates to be paid.
Try to look at your cash flow on a daily basis, and make your projections realistic with some days of payment delay and not 100% of projects that is almost-closed closing.
Don’t get in trouble in shortages, reduce your fixed costs
We have several ways to understand costs. A really useful one is to separate them into fixed costs and variable costs.
- Variable Costs - are directly proportional to your production activity. So, the more you produce, the bigger will be your total variable costs. Examples: raw material, electric power (since you need to power up your PC to work), coffee (since you need it to keep you awake :D ).
- Fixed Costs – aren’t clearly related to your production activity. So whether you have zero or one million projects they will still be the same (this is enough for now, but there is more thing to know about it). Examples: Employees payment, Rent, Child Support (heh), recently bought PC installment, software subscription…
This difference between fixed and variable is important to manage your costs. Especially for freelancers and small companies, because fixed costs can kill you in shortages.
If you look at cost structure of small companies and freelancers you’ll notice that their biggest expenses are fixed. Employees, servers, advertising. So when your sales go down, you stop your production and your variable costs can be dramatically reduced. But your fixed costs will remain the same. Then what would you do? You’ll have to start cutting costs, but maybe it’s too late.
What should you do then? Well, I recommend you cut fixed costs to a low-level, where even your worst sales prediction could pay them (read more about it below), and turn every cost that you can into a variable cost. Pick up pay-as-you-go plans, put variable items in yours employees payment (like production bonuses, sales commission…). You could also make easier to cut a fixed cost, like reduced compulsory threshold contracts.
Feeling like the money ends before the month? You need to know your break even point
Ok, now you know about fixed and variable costs. Another nice topic related to it is your break even point. This point is where your sales are exactly the same as your expenses, so you have zero profit, but also zero loss. Wikipedia defines it as:
“[...]the point where the total revenue is just sufficient to cover the total cost.”
Maybe its graphical representation explains better the concept
So, as you can see in this case we break even when we sell 7 items, or $1,250.
Thus, when you look at your break even point you know what you have to sell in $$ or quantity in order to not have a loss. You can get this point with an easy formula:
B.E. = Fixed costs / (Price – Variable Costs)
Let’s say your fixed costs are:
- Software subscription – $900 / year
- Rent – $1,000 / month
- Server – $50 / month
And your variable costs is:
- Service costs – 30%
- Taxes – 20% (Brazil)
- Savings – 10% (read more below :D)
So you know that you have $1,125 in total of fixed costs per month. If you charge U$75/hr you have to sell at least 37.5 hours just to pay all your bills (U$1,125 of positive cash flow to cover the upcoming negative cash flow). You should look at it now as a goal, so you’ll to do anything to achieve it.
To make easier, let’s break up your goal into 4 working weeks in a month. Now you have $282/week to sell.
If by the end of week one you get just $200 that means next week has to be good and you’ll have to get at least $364. And, if by the end of the month you still have this debt to cover, then maybe it’s time to make special prices or work more hours so you don’t have a negative cash flow.
Start your savings account NOW
This is important, for example to save you when you have negative cash flow or when you see a good investment opportunity.
Study shows that 60% of small business owners fear not having enough money to retire. Don’t know about you, but I really don’t want to work from my bed when I’m 70 :)
So be it $10, $100, $1,000, it doesn’t matter the figure itself, what matters is the mindset to do this on a monthly basis for a long time. There is not much to say about it, but one thing that really works for me is see it as an expense. I keep it on the same level as my rent or my lunch, I have to pay it, or I’ll get in trouble.
It’s like Itau’s ad says “You or your money will have to work to the rest of your life”. Which one will you choose?
What do you think about it?
All this tips are pretty easy to implement. And these concepts are really useful in a wide range of situations. So, did you know about these things before reading?
I want to hear from you now, do you find it useful? Want to hear more about finance (for freelancers and small entrepreneurs, of course)?