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5
Debits versus credits
CREATING FINANCIAL HEALTH

You can commit two mortal sins as the leader of a social enterprise. The first is not admitting that you know too little. The other is thinking you know it all. Nowhere are these sins more deadly than in the area of finance.

No money, no mission—it is that simple. And it is why you can’t afford not to have a realistic understanding of money, of how it works in a social enterprise, and of your own financial literacy.

■ UNLOCKING THE FOURTH PARADOX
Continuously develop your financial literacy.

We want to arm you with practical knowledge. This chapter is not meant to turn you into a financial Wizard of Oz. It is grounded, instead, in a few key points you can use to guide your social enterprise. If you are already competent in the area of finance, we’d like to offer a few items to add to your toolbox. If finance is not currently part of your skill set, then do not let this be the last reading you do on the subject.

In this chapter, we will teach you some insider tips, provide some good financial advice, show you the gaping holes in your skill set and begin to fill them, and most importantly, inspire you to learn more.

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Counting Money

We have enormous respect for Luca Pacioli, the Italian mathematician credited with inventing the double-entry book keeping system in Venice in 1494. It’s no wonder the merchants there were of such renown. His remarkable system has stood the test of time and become the universal language for describing how money works in a business.

We speak a lot of the trade-offs and paradoxes that are part of the social enterprise world. Double-entry accounting defines those trade-offs in quantifiable, tangible terms. Its one simple rule—that every debit creates a credit, and every credit a debit—elegantly and perfectly portrays the financial cause and effect of every decision an enterprise makes.

■ PRACTITIONER’S TIP
Debits and credits define cause and effect.

The discipline and diligence of Pacioli’s system produce the two financial statements without which your enterprise cannot operate with any degree of intellectual honesty or surety. The income statement tells you what just happened (over any period of time you care to choose). The balance sheet tells you where you are at right now. Only with this understanding can you have any clue at all about what to do next.

It matters not whether you are running an Enron, a dotcom, or a hot dog stand, much less any of those with a primary social mission. You must understand how to count the money that flows in and out of your enterprise and how to read the statements that portray this. Uninterested as you may be in ever becoming an accountant, you must come to terms with debits and credits. You will never regret learning the fundamentals of double-entry accounting. Take a course at a community college 67or online or pick up a copy of Accounting for Dummies and you’ll be well on your way.

The Money Model

Pacioli gave us a system that can describe how any enterprise is doing. Everything that happens in the enterprise can be described using some combination of five simple classifications:

• Revenue: Sources of income for the enterprise
• Expenses: Payments necessary to run the enterprise
• Assets: Items of value owned by the enterprise
• Liabilities: Amounts owed to outsiders
• Equity (termed “fund balance” in nonprofits): Amounts owed by the enterprise to its owner—in other words, what the enterprise is “worth”

These concepts may describe any enterprise, but yours is not just “any” enterprise. It’s your enterprise, which makes it a unique organism with its own dynamics. These five classifications, and all of the subclassifications within them, can be used in endless combinations to describe what has happened, where you’re at now, and what could happen in the future given various courses.

What makes your enterprise tick? Two or three key dynamics drive the financial success of any given enterprise. Rebuild happens to have three:

• The conversion rate on online leads, which drives revenue and the cost of revenue
• The placement rate for program graduates, which drives labor cost, the single highest expense item
• The markup rate on sales, which drives gross margins

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And Greyston has three different ones:

• The raw material yield, which reveals the percentage of in gredients that is converted into finished products
• Pounds per labor-hour, the key measure of labor efficiency
• The market rates for cocoa, butter, flour, and sugar, which drive ingredient cost, the single highest expense item

Whatever the dynamics in your enterprise, your job is to understand them intimately, make sure everyone else in the organization does as well, monitor these dynamics constantly, and then be relentless in making them work in your favor.

■ PRACTITIONER’S TIP
Ask yourself, What are my three key dynamics?

Having Money ≠ Making Money

We entrepreneurs are an optimistic bunch. If we weren’t, we wouldn’t start businesses in the first place. And so when we plan, we are inclined to plan for immediate success. Most of us do not anticipate the amount of time and capital it will take to become a sustainable organization.

What do we mean by sustainable? At the end of the day, cash is king. Thus, sustainability means that more cash is coming in than going out. Better yet, it means the cash coming in covers the cost of the next sale until the next cash comes in. How much cash does that take? More than you are thinking right now. Whatever amount of cash you think it will take to succeed, multiply that by some big number and you might be close. For good measure, double that number just to be safe.

You must distinguish between making money and having money. When you book a sale of a product or service at a higher dollar amount than your cost, you show a profit. You’ve made 69money. But until you have collected the payment for that sale, you don’t have any money other than what you had before you began the sales process. In fact, you probably have less.

Let’s say you are selling salad dressing, like a certain social enterprise we all know and love. You sell the distributor $10,000 worth of salad dressing. The cost of goods sold (the ingredients, the packaging, the labor, and the shipping) for the salad dressing is $5,000. This is a pretty good deal on which you are going to make money, correct? The only issue is that the distributor promises to pay you in thirty days (and may realistically take thirty-five or forty), but you have to pay your employees next week and your suppliers in ten days. (Many suppliers will ask you to pay them up front if you are a new business.) Now you accept a second order from a different distributor for the same amount in the same month, and the cash scenario repeats itself.

In the early stages of your business, who is going to pay your bills while you wait for payment from your customers? At the outset, you may have some customers who are particularly fond of you or your mission and who may help by paying immediately or quickly. But if you do not secure ad ditional working cash, your growth will be limited by this factor. If you did not account for the fact that you would need at least $10,000 in cash to cover the costs to make the two sales mentioned, you will be out of business.

In fact, this is a very common occurrence. Businesses with good ideas run out of cash all the time. They are under -capitalized because their leaders miscalculated either how much money they needed or how fast they were going to get it. In either case, when it came time to pay the bills, they did not have the money. The banks foreclosed, the suppliers stopped delivering, or the employees stopped coming to work because they couldn’t get paid.

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■ PRACTITIONER’S TIP
Learn the simple tricks of cash management.

We spent a portion of chapter 3 discussing the raising of money. But raising money is a lot more work than learning how to manage it. Five simple tricks are worth mastering. They are simple, they are straightforward, and they work.

• Get long terms from suppliers: Be up front with your suppliers about what you are creating. Get their support by getting their agreement to extended (forty-five-, sixty- or even seventy-five day) terms. It never hurts to ask. You’ll be surprised how many say yes. As Jim Fruchterman points out, “It’s nice when your vendors lend you money.”¹
• Give short terms to customers: Again, make this an up-front conversation with customers. Explain that your terms are ten-to-fifteen days and lean on their sympathy for your social mission if you have to.
• Bill quickly: Eenerate an invoice the moment your product leaves the shipping dock. Better yet, directly bill your customer’s credit card so you get the funds the same day.
• Make friends with your customers’ Accounts Payable departments and your vendors’ Accounts Receivable: Know whom to call when you really need to get paid now or when you really need another few days to pay. Communicate constantly.
• Minimize production cycles: Working against your cash position is the cost you must invest in buying raw materials and paying labor before a product ever ships. Speed up the production cycle and you’ll reduce the number of days between the making of these investments and the realization of a return on them.

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Making Money ≠ Making Sales

Just as having money is different from making money, making money is different from making sales. Probably the biggest mistake social enterprises make, after not understanding cash, is not understanding profit.

You may have made the sale. You may have delivered the product or service, and you may even have gotten the cash in before you sent the cash out. But did you made a profit? It de -pends on whether you accounted for all your costs. If you sold a product, did you account for the raw materials, the waste, the labor to produce and deliver, your insurance, your rent or mortgage, your utilities, your supplies, your research and development costs, your administrative staff costs, your sales costs, and so on? If you sold a service, did you cover all of the above, less raw materials but including the labor to perform the service?

Just because you got paid does not mean you have made money. Critical to the needed understanding of finance is at least a conceptual understanding of cost accounting. Cost accounting is the process of allocating expenses and asset utilization to specific production units, product lines, or departments so that true profit margins can be determined.

The simple part is accounting for the variable costs of a sale, the actual raw material and labor inputs to the finished good, which go up or down depending on how many units you sell. Where more businesses stumble is on the apportionment of the fixed costs, many of which are described above, to the product units.

This is a bigger problem for social enterprises than for regular businesses. On top of all the normal fixed costs, you will have certain costs, both fixed and variable, that relate 72specifically to the delivery of the social mission. These tend to be softer and more difficult to calculate than typical business costs. Once identified, they are harder to allocate. If you assign them as product costs, you may price yourself out of the market. If you don’t, how will they get paid? You can lower your profit target, but that will slow your growth. You can try to pay for them outside the product: in a nonprofit, by finding philanthropic support; in a for-profit, by convincing your equity holders to accept a lower return rate in consideration of your social mission.

Or, as we posit in chapter 7, you can use your social mission and the related costs to position your product at the premium-pricing end of the market, as Greyston is attempting to do with its launch of the Do-Goodie gourmet brownie.

■ PRACTITIONER’S TIP
Develop cost accounting practices that include
the cost of the mission.

Spending Money

Even if a business can be kept going for some amount of time, being cash poor leads to bad decisions. A social enterprise cannot save its way to prosperity. At some point, it must invest real dollars into operations, real dollars into seeking out good personnel, real dollars into infrastructure, and real dollars into raw materials, or supplies. This issue will weigh on your decision making if you do not have real dollars.

Kevin McDonald started TROSA with a dream and virtually no cash. Knowing what he now knows, that’s an approach he wouldn’t repeat: “I’d never do it again without some front money… There would have to be capital up front, or whatever you guys call it, because I wouldn’t do it again with $18,000 in my life.”² 73Yes, people have figured out ingenious ways to get past a lack of cash. After all, necessity is the mother of invention. And people take pride in bootstrapping their businesses. But cash-poor businesses operate with a poverty mind-set that perpetuates itself by trapping them in a cycle of continued poverty.

All businesses must spend. So in place of a poverty mindset, we recommend a frugal mind-set. Let’s look at how the poverty mind-set impacts personnel decisions compared to the frugal mind-set. The poverty mind-set says don’t spend anything. The frugal mind-set says challenge whether you need to spend or not. The poverty mind-set says you don’t need to hire; you can do it all. The frugal mind-set says don’t hire beyond your needs. The poverty mind-set says hire the most inexpensive person you can find. The frugal mind-set says hire at the price you need but nothing more. If you can’t beg, borrow, or steal the dollars to invest in the minimum necessary level of personnel, then you shouldn’t be in business.

■ PRACTITIONER’S TIP
Have a frugal mind-set, not a poverty mind-set.

Even if you live with a poverty mind-set, you will be unable to do right by yourself, your employees, your business, and your customers. Everyone will suffer from a lack of investment into the business.

Talking About Money

By now it should be clear that you must have, at a very minimum, a good grasp of how money works. This is not to say you must be the leading expert in your organization. In fact, your management team must have complementary skill sets. 74Every enterprise must have people with a sales skill set and an operations skill set. It must also have people with a finance skill set. When they started Give Something Back, Mike Hannigan and his partner brought complementary skills. Sean Marx is a sales and marketing guy, while Hannigan is more of a finance and administrative guy. Hannigan happened to be the one who could provide the financial guidance his team needed during their early stages. He understood cash flow and its impact. He understood his business’s costs and how they related to pricing. He understood the importance of financial discipline and how the proper preparation of financial records would influence not only how they would do business but how they could talk with potential investors.

He also knew how to relate to banks:

Hannigan may be an extraordinary example, but let’s face it: many banks, investors, and savvy funders do not have the highest regard for the financial acumen of nonprofit managers. They are suspicious of for-profit social enterprise managers 75as well. They don’t understand how someone can have a soft heart while possessing good financial skills and the discipline to apply those skills effectively.

When you meet with the providers of capital, you must immediately dispel these thoughts with respect to yourself and your managers. The surest way to do this is to introduce them to someone in your company who knows your numbers and is in a position to do something about them.

The fact that you have a financial expert on your board who shows up once every two months will not suffice. Yes, it helps to have engaged board members who can speak intelligently about your company’s mission and numbers, but the bankers and investors want to know that you have a manager looking after the assets of the company. They want to know that someone in a position of operating authority is watching the store. They want to know you have someone who understands the financial aspects of your business plan, someone who can create and monitor your cash flow. They want to know you have someone who understands the implications of loans, accounts receivable, and accounts payable.

■ PRACTITIONER’S TIP
The enterprise must demonstrate an institutional grasp of money.

This is not an area where you can fake expertise. Your own literacy is critical but not enough. Develop your financial bench strength as well.

Watching the Money

What systems do you need to have in place so that you can watch the store?

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Shari Berenbach of Calvert Foundation gets to look at dozens of social enterprises and has concluded that a lack of basic accounting and finance systems is a substantial weakness:

One reason for this weakness, particularly for nonprofit social enterprises, is that they typically spin out of organizations that have very different accounting systems than the kind needed for a social enterprise with moving parts. But Shari’s plea for better accounting systems applies, whether you come from a for-profit or a nonprofit world.

Systems provide you and your staff the numbers you need to guide your enterprise. These numbers tell a story if you can read them. A few simple ones are absolutely indispensable to any business and universal to all (and notice that the first four are about cash):

• Cash on hand: What you actually have in the bank once every outstanding check clears.
• Accounts receivable: The amount companies or people owe you for products or services sold on credit.
• Aging of accounts receivable: The amount of time companies or people are taking to pay you.
• Accounts payable: The amount you owe companies or people for products or services sold to you on credit.
• 77 Aging of accounts payable: The amount of time you are taking to pay.
• Cash flow: The amount of cash coming and going over some period of time, which is really nothing more than cash on hand plus accounts receivable minus accounts payable over time.
• Revenue: The amount you have invoiced customers (or booked as donations) over some period of time.
• Cost of goods sold: The expenses directly associated with producing sales, usually including raw materials, direct labor, and distribution.
• Overhead: All of the other expenses, including rent, leases, utilities, advertising, insurance, and administrative salaries, that can’t be neatly tied to the production of revenue. (Note to self: You are overhead! Make it not be so. Do something every day to create revenue.)
• Debt service: The amount you must pay to lenders.
• Depreciation: The reduction in the value of your assets that occurs over time, a tricky noncash expense that essentially funds future asset purchases.

Build a system that delivers you these numbers accurately and on time and you will have the means to succeed. We recommend creating a weekly dashboard, separate and distinct from monthly or quarterly financials, that focuses solely on these key indicators.

■ PRACTITIONER’S TIP
Use a weekly dashboard of key numbers.

Reports need to be simple enough to produce timely and, more importantly, actionable information. While every enterprise will have a different dashboard based on its key dynamics, 78it’s a pretty good bet that some sort of cash flow report will be a part of every one.

Cash is one of just two key indicators that serve as Walls’s daily compass. He reviews Greyston’s cash analysis weekly with his accountant. His short-term cash flow is a simple six-week chart based on a simple calculation that anyone can use:

■ THE PRACTITIONER’S CASH-ON-HAND CALCULATION
Starting cash + expected collections - expected payments = Ending cash

He uses six weeks because this is the longest horizon for which he realistically knows his exact sales and collections. His customers place orders two to three weeks in advance and, depending on the customer, he receives payment three to six weeks thereafter. So he can fairly accurately project receipts from customers. Based on this projection, he can also estimate what he will need to pay out on the credit purchases he needs to make to complete his orders.

The other key number he looks at is his current ratio—probably the most widely used liquidity analysis. Typically a current ratio compares all current assets (cash, accounts receivable, and inventory) against all current liabilities (accounts payable and all other payments due within the coming 365 days). He uses a modification of this, eliminating inventory, because his inventory value does not fluctuate much on a weekly basis.

This is a crude method, but it never fails to point out areas of concern. The ratio should be at least 1:1, meaning he will have one dollar of cash coming in for every one dollar of cash going out. If it is not at least 1:1 but less, say 0.75:1, then at some point within the next 365 days he will not have enough cash to make his payments.

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Getting Good at Money

If you are going to change the world, your enterprise must rise to a level of impact. It takes money to grow. And as we have seen, it takes even more money to accomplish the common good. So anything a regular business does to become good at dealing with money, you must do doubly.

If you don’t get good at gathering and then redeploying money, you’ll never get a real shot at creating the common good. You create capital by understanding money, managing it, growing it, and attracting it. If you learn to do that, then you can build something quite amazing.