The Three Invisible Legs
Warning: Non-traditional post….and a bit longer than normal. I felt conflicted, but ultimately decided I needed to take this tangent today.
Shockwaves were recently sent through my community when a popular restaurant unexpectedly closed. It's a newer restaurant that's known to be quite busy. Social media was abuzz, with many commenters dumbfounded by how a business as busy as this can't make it financially.
There were, of course, the obligatory comments about tariffs, evil landlords, how there are already too many restaurants, and people not "supporting" small businesses (which is ironic considering the place was constantly packed).
Several people sent me news articles about the closure, asking for my perspective. As a society, we judge how good a business is doing by how much traffic it has. After all, it's tangible. More people equals more revenue, and more revenue equals more profit.
Today, I want to discuss what I refer to as the three invisible legs of business. Like a real three-legged stool, a business needs all three of these legs to stand firm. If one or more is missing (often the case), the business is at risk of faltering. With that setup, here are the three legs:
First, capital structure. This refers to how the business is funded. Some businesses require little capital to launch, creating little to no capital structure tension. However, if a business owner relies heavily on debt, the financial burden of this capital structure can feel heavy. Consumers can't see how this dynamic silently and brutally plays out behind the scenes. The moment a business owner creates the capital structure is the moment a certain level of risk/pressure is introduced (or not).
Second, overhead. One of the other hallmark moments that defines a business's financial fate is when its overhead is established. Think about these as fixed costs. Rent, utilities, insurance, software, labor (for non-service businesses), etc. These expenses must be paid whether or not a single penny of revenue is generated. And depending on how the business owner approached this, it can feel anywhere from light as a feather to an anvil tied around your ankle.
Third, gross margins. This is one of the least understood nuances of business.....even among business owners. The gross margin is how much profit each good or service generates when sold. For example, if a retailer buys a t-shirt for $10 and sells it for $15, it generates a 33% gross margin ($5 profit divided by $15 sale price). However, the underbelly of gross margins in most people's businesses is that they don't account for the full cost. Let's use the same t-shirt example. Not only do we need to include the cost of the shirt, but also the card processing fees, tags, bags, and any other nuances. Let's say these costs account for an additional $3. Instead of a $5 profit, it's actually only $2.....which is a 13% gross margin. Margins matter so much! If a business doesn't have satisfactory margins, they won't even be profitable if they sell a billion dollars worth of goods!
This is where all three invisible legs get slotted together. There needs to be enough sales at a high enough gross margin to overcome the capital structure and overhead.....plus enough to provide a sustainable profit. All three legs matter so much, and this is where many businesses are whiffing. It's a simple concept, but difficult to execute.
I’ll close with an example:
Business A generates $45,000 of monthly revenue at a 35% gross margin. That’s $15,750 of gross profit. After subtracting $11,000 of overhead and $4,000 of debt payments, it has $750 of profit remaining.
Business B generates the same $45,000 of revenue, but at a 50% gross margin. That’s $22,500 of gross profit. After subtracting $7,000 of overhead and $1,000 of debt payments, it has $14,500 of profit remaining.
It looks the same from the outside, but behind the curtain, Business B is making nearly 20x as much profit on the same amount of sales. These dynamics can be staggering!
Consumers, hopefully you find this interesting and make you see things differently next time you go into a business. Business owners, please focus on these three legs; your survival and success depend on it.
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