Cannabis Cultivation: Understanding Your Profitability
Endemic to the cannabis cultivation business is a significant timing difference between upfront expenses vs delayed revenue receipt compared to other verticals in the cannabis industry. Especially with cost-basis accounting, it is difficult to discern the underlying value of a cultivation business by merely looking at an income statement. In this piece we’ll explain how to prove the value of a cultivation business.
Cannabis cultivation entails up-front costs without returns until a crop has been harvested and sold. Cultivation sites have expensive build-outs and require considerable square footage. In addition, there is all that cash needed to acquire, house, and nourish juvenile plants until they are harvested. To make matters worse, cultivators are always shelling out more cash to either scale up and/or finance subsequent crops.
At first glance, especially using cost basis accounting, a cultivator’s financials look bad (especially in those first 18 to 24 months) since outflows are being dumped into COGS, compared to the meagre amount of cash coming in. What is worse, the timing delay between up front expenses and delayed revenues, the income statement continues to show losses. Conversely, accrual basis financials reveal improved performance. This essentially means that you're not going to immediately flush all costs directly into COGS. You're first going to build up inventory and then run these costs to COGS as your products are sold.
Let’s consider a few ways to improve the value of your cultivation business so that when you present the numbers, there's reasonable methodologies behind your business’ valuation. Begin by creating and documenting standard operating procedures. Now I know this sounds very basic, but when we go into our engagements for CFO work most clients don't have detailed documentation around their operations. Wondering where to start? Here’s what we advise:
Document every position's daily tasks.There are many tools out there for SOP tracking, but in a worst-case scenario just use a word processing document. In addition to other benefits (lower training cost), one’s exit value could be higher as buyers are able to repeat your success without you or other critical actors within the business.
Implement formation tracking systems. This comes up in almost every one of our proposals, because most businesses do not have the best information tracking systems, or the granularity needed to make a thoughtful analysis of the business.
Again, as stated earlier, the financials might seem very lopsided. So, with these systems, you can prove profitability sooner. It also creates discipline and accountability for workers at every level in the business. Measure it all and manage it as you see necessary. You should track everything, but choose a handful of KPIs to monitor closely that give you an overview of the entire enterprise: costs, revenue, how many pounds per plant, how many grams per square foot, how much time was spent at each part of the process and by whom (rate per person), etc.
The best way to improve the value of your cultivation business is knowing your true costs per pound. Now, you may think, “Hey, I know my cost per pound!” However, in our experience very few cultivators know their true cost per pound. Most people look at consolidated financials and divide total expenses by the number of pounds produced. That methodology only works if you have a single grow area with one strain, which is likely not the case for a majority of cultivators. You’re going to have more than one veg room. You're going to have more than one bloom room. You're going to have more than one strain.
Let's review a high-level walkthrough for calculating cost per pound. This is where your systems are incredibly important because every expense needs to be tracked to be as granular as possible. Allocating direct expenses is relatively straightforward - when you buy nutrients, for example, you can pretty much tie back to a specific strain or a room. The more thoughtful analysis comes with indirect expenses. So you'll need to develop a reasonable methodology for things like rent, insurance, and other SG&A expenses. You can use job codes or project codes to allocate these expenses. You can figure these out as you move through the business, but everything needs to have a reasonable process because someone will inevitably ask “how was cost per pound calculated?”
Once you understand how to highlight the value of a cultivation business and put some evidence behind the numbers, you can talk confidently to your internal stakeholders, external stakeholders, and even teams within the company. Let’s begin with the importance of margins. It's less expensive to grow outdoor product than indoor product, because there is no electricity cost for outdoor. But what is the margin of the indoor versus the outdoor product? This leads us to a discussion about the sales price. If outdoor flower costs $319 per pound and sells for $650 per pound – the profit margin is 51% With cost per indoor pound of $52 and selling price of $1,300 - your margin is 60%. Being able to show accurate margins to owners and potential buyers helps you to truly demonstrate the profitability of your business.
Every other business in the industry, from manufacturers to retailers, can show their profit margins at a very granular level, down to the product or type of oil. Cultivators need to be able to do the same.
Next, you’ll want to know and be able to evaluate your historical data. This cannot be overstated since being able to see lines (which are trends) and not dots (moments in time) is incredibly important. Investors and stakeholders want to see trends to know how revenue and expenses are moving. So if you want to exit from this cannabis cultivation business in the next 12 to 48 months, start tracking your data now so that when you go to sell the business, you have numbers to support your valuation. Fact-based data is superior compared to someone who just grows a lot of cannabis but has no way to prove profitability.
Hopefully this article has provided some value and helped you to understand the financials of cannabis cultivation, businesses, how to improve its value and how to present financials in a powerful way. We do this work for all of our clients, where we function as a virtual CFO. So clients know what levers to adjust, how to optimize their business, how to report back to investors and teams.
Scott Tindall
Advisor
If you need help analyzing your cannabis cultivation business financials, please email us here. We can’t wait to talk with you!
The information contained in this presentation is meant for guidance purposes only, not as professional, legal, or tax advice.