This is a question we hear a lot. It can be difficult to get a handle on your small business finances. Orders are coming in, bills are being paid, and there’s money in the bank. But how can you tell whether or not your business is profitable? There are several factors to consider. You may have money coming in from sales, but determining if your expenses are covered by profit is not as simple as it sounds.
Your business will have startup costs that go away over time. Whether you’ve paid those costs with an initial investment or have taken out a loan, you have to consider repayment of those startup costs in your profitability statement. Loan payments are a part of your expenses.
The formula for determining your profitability is [Revenue – Expenses = Profit]. Revenue is your income from sales. Sometimes you’ll be getting income from point of sale purchases. An item is sold or service rendered and you receive payment immediately. Those transactions are easy to add up. However it’s likely your income does not get attributed directly. Customers may have a payment schedule. You may be waiting for payments from retail outlets. Your payments may be tied up in insurance reimbursements if you’re a healthcare provider. That’s why it’s important to evaluate your profitability in the short term and the long term. Look at your monthly and your yearly income statements. You could be working today for money that’s coming in three months from now.
Expenses are the cost of doing business. This includes the cost of making your product or providing your services, labor, and overhead. Overhead is the operating expenses of the business including rent or mortgage, utilities, equipment rental and repair, and insurance. Some expenses will be fixed from month to month like your mortgage. Other expenses increase as your business grows, like salaries as you hire more employees. There are even expenses that will decrease as your business grows, like products that become cheaper per unit as you order inventory in greater numbers. Shipping rates can also go down as you ship in greater volume. Updating your expense report will ensure accuracy in your profitability calculations.
Another important number in determining profitability is the cost of goods sold (COGS). This is [Revenue – Cost = Profit]. The cost includes labor, materials, and overhead. Once you determine your COGS, you can calculate your profit margin. Profit margin needs to be high enough to cover expenses. If you have a low profit margin then you need to do a high volume of business. If you calculate your profit margin and it’s decreasing over time, then it’s time to increase your prices or cut costs.
There are several ways to increase your business profitability. You can focus on the clients that bring in the most profit. If you don’t already know who your best customers are you can calculate the profit margin on an account-by-account basis. Spend your time developing the accounts that bring you the most money. Reduce expenses where it makes sense. Try to negotiate better interest terms with lenders to reduce loan payments. Always negotiate with vendors to get the best deal possible, and remember to renegotiate as your business grows. A few small changes and your business may be closer to profitability than you think.