Business Profitability is Your Return on Your Investment … It’s Your Profit
Business profitability is the main and sometimes the only reason why all entrepreneurs are in business, it is the motivating factor of any capitalist economy.
We get up in the morning and go to work, day after day, week after week and month after month simply to produce profit.
That magic word profit, is the measure of your success. Your return on investment for your time and your money in your business.
Profit … What a magic word that is.
If we did not profit in some way from everything we do, then it is doubtful that anything would ever get done.
We profit from our education, friendships, marriage and from our business.
Have you noticed how soon people get out of all these aspects of life, as soon as the profit does not meet with their expectations?
From a business point of view, you need to understand business profitability and how to use it to grow your business.
You must be able to measure it and know how to increase it. Let’s first define profitability.
What is Business Profitability?
All expenses and outlays minus your revenues will leave you with your profit or loss. If the revenue exceeds expenses, you have a profitable situation and if not you lose. it’s that simple.
- Income received from investments or property is profit.
- Selling anything for more than it cost you gives you a profit.
We can and do have different types of profit, for example operating profit, net profit before and after taxes, return on investment, etc. All however tell us if we are in profit or are in loss.
The Measurement of Business Profitability
In business we tend to measure profitability in quite a number of ways, the use of the profit and loss statement being the main one. This I will run through with you in a minute.
Having been in my own business for over 12 years and with a good financial manager to guide me, I prepared and used all of the statements that are commonly drawn up by all businesses.
The Profit and Loss Statement …
The P&L or income statement will show you how your business is generating cash over a period of time. Business cash flow is vital to the survival of any business, so study your P&L in depth.
It shows you what you have brought in and what you have spent. Very useful information to have at your fingertips.
Make sure that you have your monthly P&L on your desk within ten days of every month end.
With these two documents at hand, you will be able to clearly see your business profitability and be able to make decisions based on fact and not guesswork.
Now that we know what profitability is and how to measure it, let?s find out how to increase it.
Capital Expenditure Forecast … ROI
I always relied on one method of testing for profitability that always worked for me. Here is my Capital Expenditure Forecast method.
This return on investment method is ideal for estimating the business profitability of any proposed new investment.
It can moreover be used to look at the worth of a new store, a new production line in a factory or a new delivery vehicle.
To put the calculation together you will need the cost of the project, which is all costs including buildings, machinery, inventory, stock, etc.
Your expected calculated cash flow from the new project is then divided by these costs.
Finally you divide this result by the number of years that you have been in the investment.
An example will help your understanding here.
Let’s assume you are in the plastic injection moulding business and want to put in a new line.
You spend £150,000 on the building and machinery and you estimate that first year earnings will be a negative £30,000.
So: -30000 / 150000 = -0.20
Your return on investment (ROI) is therefore minus 20 percent.
During the second year your earnings are much improved at + £90,000
Now cumulatively over the two years you have earnings of £90,000 in year 2 less £30,000 in year 1, leaving net earnings of £60,000 over two years.
So: 60000 / 150000 = 0.40
Your ROI (Return on Investment) is now a much improved cumulative plus 20 per cent.
And so on.
What does this method of calculating business profitability all mean?
If your investment does not turn a profit within three years, (four years tops), you might want to consider dropping it. At the end of three years your ROI needs to be at least 33 percent.
If you can’t get your investment money back within three years and start turning a profit, then all the other variables like inflation, replacement costs and upgrading will overtake you and you will never make a profit.
If you are in business already and haven’t done this ROI calculation, get your accountant to do it for you, based on your past years statements. You might find it very interesting.
Remember … Profit or business profitability is all about your return on investment. So watch it carefully.
How do you increase business profitability?
If you have excessive profits lying around you are wasting opportunities. If you are short of profits, your business is at risk.
The main duty of anyone in business is to ensure that potential profits are not wasted and existing profits maximized. Maximized by good practice and not by profiteering, which in my view is unethical and a very short sighted business practice.
We all want to improve business profitability? Here are some suggestions for how to do that.
1. Cost Containment …
One of you and your chief financial officers or managers more important jobs is to increase profitability by either selling more or reducing costs, hopefully both. This is a never ending job, always ongoing and really starts with the delivery of the P and L statement on your desk.
All good businesses are lean and constantly aim to trim any fat. Many businesses have grown fat only to find this adversely affects profitability and long term survival. Cost containment is vital to success.
2. Analyze the Profit and Loss Statement (P&L) …
Study it closely and check the value of each and every expense. If the expense adds value to the customer and its cost is recovered through a better and higher value product or service, it is probably justified. If it adds nothing to the bottom line, it must be removed.
- Are you paying too much for goods and services? Getting the discounts you can? Only paying early if you get a discount?
- Are your suppliers making it worth your while to stay with them?
- Are you paying your people what the market dictates, or are you overpaying them?
- If you are more than a one person business and have various departments, you should watch each departments costs. Often a badly performing, high cost, department can be hidden in the overall picture.
- People are a cost to a business, so bad performers cost you money. Don?t pay for inefficiency. Weed your garden.
- Look at the efficiency of your processes, be they in handling, manufacturing, distribution, or anything else. Can you improve and so cut costs.
- How do you handle your stock inventory? Redundant or very slow selling inventory costs you money.
3. Plan to Grow …
To survive and thrive every business must grow.
In order to cover rising costs, to be able to withstand competition, and to be able to invest in new technologies you must plan to grow.
The planned growth of a business can improve business profitability, so always be aware that you need growth. When planning, look ahead and plan your proposed growth over a period of 5 and 10 years.
Before you grow however, you need to check out a few things to ensure that you have them in place and you are ready to grow.
- Have you the extra skills you will need? Are you building those skills internally ready for expansion? Will you have to hire them?
- Have you a product or service that can be sold elsewhere? Does it have rising demand? If it is a fad product or just a lucky one, are you sure that you can expand it profitably?
- Have you in place systems that can be replicated or can withstand growth? With more people and/or extra locations you will have many extra problems. Can you manage them?
- Have you decided how your growth is to take place, simply by more outlets, appointed agents or by franchising your business model or ideas?
- Have you the money or can you arrange to borrow funds for any planned expansion?
Business profitability can only be improved by cutting costs or increasing sales.
You need to keep that in mind at all times, to ensure your business success.
Don’t forget the little things though; they can often improve business profitability greatly. Get them right from the start, so watch …
- Your product mix. Are you supplying what your customers want?
- New items and new technology that you can sell or will reduce costs.
- That you?re packaging is appealing and adds value.
- Your appearance. Does your business look appealing to the customer? Are they attracted to your product?
- That your signage is excellent. Good advertising is a must. Clean, bold and in the right place. Washed monthly and painted annually.
- That you are advertising in the right media and measuring the results.
- That you guard your good reputation religiously.
Just like every other aspect of your business, good management is essential if you are to increase your business profitability.