Every business owner has a big vision for their company and wants to make it happen. However, when the owner is struggling with making the company bigger, they often get confused or frustrated that it’s not happening.
They didn’t teach you how to grow your company in college and there’s no on-the-job training when you’re the CEO. It shouldn’t be so hard to have a company with increasing profitability.
In our last post, we discussed the balance sheet, and you heard the acronym PALL (Profitability, Activity (AR and inventory turns), Liquidity, and Leverage). In case you missed it, you can check it out here.
Today, we’re going to talk about the income statement, or the profit and loss statement. This is the one that most business owners are familiar with. The income statement measures profitability; specifically, revenue minus expenses. Expenses fall into 2 categories: before and after operating expenses.
I have a client who has doubled his revenue in the last five years. First, he had to understand his financials, then he went on to know what levers to pull to increase his profitability. The impact on his profitability has been an increase of 350%. Most people don’t know that a 1% increase in revenue has an 8-10% increase to profitability.
A quick reminder on definition of terms:
Gross profit and gross profit margin are the number and percentage of gross profit. This is before operating expenses.
After revenue, you have either Cost of Goods Sold (COGS) or Cost of Sales (COS). If you’re involved in making or reselling a product (goods) then you have labor and materials or a product in COGS. If you’re a service business, there is no product, just services. So, the COS is the labor it takes to deliver the service.
Your Gross Profit = Revenue – COGS or COS. Your Gross Margin = Gross Profit divided by Revenue, which is expressed as a percent.
Net profit and net profit margin are the number and percentage after operating expenses.
- You have both fixed and variable expenses. Keep your fixed expenses as low as possible like salaries, rent, utilities, and insurance.
- Your biggest fixed expense is people and this one can easily creep up. So, watch it like a hawk.
- Your variable expenses are things like commissions and credit fees. They go up or down based on revenue.
For example, if your revenue is $1 million and your COGS or COS is $500,000, then your gross profit is $500,000, 50%. If your operating expenses are $400,000, then your net profit is $100,000 and your net margin is 10% (net profit/revenue).
Once your business has hit about $1 million, your focus should be on profitability. Not just for the sake of profits, but because of the choices you have when your company is profitable like rainy day money, growth, paying down debt, or paying yourself. Profits are also the primary driver of business valuation. It’s a way for the business owner to keep score.
P.S. The typical percentages for gross and net profit margins depend on your industry. Want to know how your gross and net profit margins stack up against your peers?
You might want to consider getting a Business Financial Check-up. Benchmark your performance and gain an understanding of your business financial health.