Running a business comes with many challenges. One of the biggest can be understanding the overall financial health of your business and what profit your company generates. Using your bank account balance as a guide can be a useful indicator for small businesses, however without financial statements it can be misleading.
A way to determine if your business is profitable is to prepare a profit and loss statement. This will show you how much profit your business in making. Using profitability ratios, such as gross and net profit margin, helps business owners measure profitability and plan for future growth.
Cash flow can be the main factor that keeps a business owner up at night, and the natural reaction to cash flow problems is to focus on increased revenue. However, if it costs a business more than what the products and services are being sold for, increasing sales numbers will only worsen your cash flow problem.
Do you know how much money your business is making?
The only way to accurately understand your company’s profitability is by preparing a set of accounts. These financial statements need to include both an income statement and a balance sheet so that if you are losing money, you can see why, or in some instances, a profitable business has no money in the bank.
Sales revenue may have increased, but if customers are on 3 months credit terms and you need to pay your suppliers in 1 month, this can cause cash flow issues.
It is also important to know how much net profit the business is making, so that money can be set aside for tax and to ensure that you are not drawing too much in dividends out of a company that could have to be paid back.
How can you measure business profitability?
To measure profitability of a business the key things that every business owner should understand are:
- Gross profit
This is the amount a business sells products and services for, less the service or product cost. This cost needs to include all variable expenses such as project expenses and labour to deliver the product or service.Take a look at the example below which shows how to calculate gross profit taking a company selling security systems:The sales price to the customer is £2,000. To arrive at the gross profit, you need to deduct the product cost of £1,000 and the labour cost to install of £500. This leaves you with an overall gross profit of £500.
- Gross profit margin
Gross profit margin is the gross profit divided by the sales price x 100. In the example above this would be 25% (£500/ £2000 x 100).A gross profit margin ratio should be calculated both in total and over all products that the business sells. If a business focusses on the higher gross profit margin products it will increase future profitability.
- Overhead expenses
These are all the fixed operating costs of the business that have to be incurred regardless of services and goods sold.When calculating these operating expenses it is good practice to include remuneration for the business owner, so they know what the costs are that the gross profit has to cover.
- Break even point
The break even point is the amount of units sold to cover operating expenses.In the case of the security systems above, if they have monthly salary costs of £5,000, premises costs of £1,000, Motor Costs of £500 and other operating costs of £1,500, then the total operating expense is £8,000. If each unit has a £500 profit then 16 systems need to be installed each month to break even.
What is your net income?
Net income (also referred to as Net Profit) is the sales revenue from the business, less the cost of goods sold, less the overhead costs.
To get an accurate profit, accounting adjustments need to be made for the product cost of items not sold, depreciation of assets (such as plant and machinery, computer equipment and vehicles), expenses paid in advance and expenses not billed yet.
Once you know what your net profit is, then a business owner needs to understand if that is enough to deliver the income that they require. If not, then what actions can be taken to increase business profitability.
Profitable businesses often understand margin ratios, keep track of gross profits and understand their break even analysis.
Are you making a return on your investment?
Time is, by no doubt, the biggest investment most business owners make when starting a new enterprise. The trade off at the start, is that it is part of the investment needed to build a profitable business and increase net worth. However, once the business is established, there comes a point where the business needs to generate a profit and make a return on the time invested.
How to use management accounts for profitable business
Management accounts not only show the net profit of the business, but they can also include the profitability margin ratios that are needed to understand how the business performs.
All businesses have to have annual accounts for HMRC and Companies House. But, with a deadline of 9 months after the year end, this information is often out of date as costs have increased.
The security company above could use management accounts to help monitor their businesses financial health and increase profitability as follows:
- Tracking gross profit margin
Based on the example above, the business should be delivering a gross profit margin of 25%. Management accounts may, for example, produce a gross profit margin ratio of 20%, and there are a number of reasons for this such as increase in raw materials, labour cost taking more time than budgeted or low margin products being sold. Actions can then be taken such as reviewing pricing policies or focussing on higher margins.
- Managing operating costs
Every business incurs unforeseen expenses, and management accounts will help to spot these earlier. For example, office supplies may increase in one month, looking into this may identify that a lease on a copier the business no longer uses has expired and the company is being charged a standard rate.Management accounts can help identify the increase immediately. If, for example, in month 2 of the financial year the increase was £200 per month. Without monitoring your costs regularly, it could take up to 19 months before your annual accounts are prepared and this additional cost is spotted. That’s £3,800 additional profit you could have potentially benefitted from!
- Balance sheet financial ratios
Looking at stock, debtor and creditor days can help understand the cash flow against operating profit.Let’s use our security company again as the example. A new build development requires a security installation system in all its houses. As they are installing up to 60 units at a time they may need to hold stock of £60,000. Customers, however, may take up to 60 days to pay, resulting in debtors of £120,000, as stock may need to be paid for in 30 days. This gives a cash requirement of £120,000 to service this project.Management accounts will show the debtor days each month. So, if the customer starts paying on 75 days, this can be picked up early as whilst the project may be profitable that’s an extra £30,000 of cash tied up.
Estimating your gross profit margin
When looking at a new product or service, best practice is to estimate your gross profit margin, to ensure that the product or service is profitable and provides enough profit margin to contribute to the profitability of the business.
Calculating operating expenses
Operating expenses are all the fixed costs and expenses that the company incurs. These are the costs that would have to be incurred regardless of the total revenue of the business. They include premises expenses, staff costs that are not directly attributable to sales revenue, vehicle running expenses, insurance, travel, professional fees etc. For management accounting purposes operating expenses also need to include owner remuneration.
KPI’s (key performance indicators) are ratios that help manage the profitability of a business. These can include gross profit margin, net profit margin, debtor days, creditor days. Each business will have a set of ratios that impact it’s net profit and cash.
For example a construction company or professional services company may monitor work in progress days. This will give an indication of when job’s over run and project costs increase, but a company selling goods online, will be more focussed on break even analysis and gross margin.
Even the most profitable business can run out of cash. This is why it is important to understand your balance sheet ratios as well as profitability ratios when looking at management accounts.
The only sure way to know if your business is profitable is through good financial information and understanding this. Focusing on improving gross and net profit margin ratio will increase the operating profit of the business, and ultimately deliver more to you as a business owner.
At Spotlight Accounting, our team of experienced accountants can help you understand your operating profit, your gross profit margin ratio and net profit margin ratio is, look at your break even point so you know what needs to be monitored to increase future profitability. Contact us today for our friendly, expert advice!
Not sure if your business needs management accounting, check out our 10 reasons why management accounts are beneficial to businesses!