Every business owner’s goal is to have a successful company, which revolves around generating a healthy income. While everyone has their own monetary goals, it can be difficult to figure out how to achieve them when you don’t have the full picture of your business’s finances. Getting that full picture can take a lot of work, so Pinpoint Management has created this guide to help you learn how to keep track of profits, gain more business financial literacy, and optimize profitability.
Understand Profit vs. Profitability
The first step to assessing and improving your company’s financial wellbeing is understanding profits and profitability— and no, they’re not the same. While they are closely related, they are two different measurements, and knowing what numbers your business pulls in for both is critical to managing finances.
Profit is a concrete number indicating how much your business is earning when all costs and expenses are factored out. If you sell a product for $14, your profit is not $14 unless you got the product manufactured for free, didn’t pay advertising, didn’t pay any fees, had no overhead costs, etc. This is not common, so your business should be tracking all business expenses and profits. Here’s a simple equation for calculating profit:
Total Revenue of Business (for x time period) – Total Expenses (for x time period) = Profit (for x time period).
One common misconception is that a company that makes a profit is profitable. While $15,000 of profits monthly may look good on paper for a small business, that’s an alarmingly low number for a huge corporation. Profitability is not one-size-fits-all.
Profit describes how much money a company is actually making, and profitability describes the overall success and financial wellness of a business. It’s a relative measurement that considers many factors, like the size of the business, efficiency, and costs, to determine if a business is actually making a worthwhile return on investment.
Know Where Your Business Stands
Knowing how to keep track of profits and profitability is a key step in understanding how your business is doing. There are a lot of ways to measure profitability, both subjectively and concretely. Still, at a base level, all executives should be familiar with these measurements when discussing profitability (in addition to the net profit calculation discussed above):
Gross Profit Margin
Use these two formulas to calculate your gross profit margin:
Net Revenue – Cost of Goods Sold = Gross Profit
Gross Profit ÷ Net revenue = Gross Profit Margin
Once you have your gross profit margin number, look at that percentage. A high percentage usually indicates you are maintaining a healthy profit compared to the product costs. A low percentage can indicate you have high costs, which is still acceptable if sales volume is high.
When analyzing this number, the goal is to make sure product costs are within reason for your business. A major red flag to look out for is if your gross profit margin is decreasing. At that point, taking action is important.
Operating Profit Margin
Another key number to consider is the operating profit margin, which can be found with the following formulas:
Revenue – Cost of Goods Sold – Operating Expenses = Operating Income
(Operating Income ÷ Sales) × 100 = Operating Profit Margin Ratio
This number will give some insight into your business’s current earning potential. When analyzing this calculation, an increase is what you want to see. If you’re not seeing an increase, operating expenses are likely the source of your problem.
Return on Assets
Return on assets can help executives see if their company is being managed well or not. A high percentage is more favorable, as it demonstrates that a business is utilizing and taking advantage of its assets. It’s important to note that companies that don’t have a lot of assets will automatically have a high return on assets. Here’s the formula to view your return on assets:
(Net Income Before Taxes ÷ Total Assets) × 100 = Return on Assets
Return on Investments
If your investments have been worthwhile, you should expect to make a higher return on investment than the average risk-free investments. Switching to investments like a high-yield savings account would be more effective. The formula to calculate your return on investment is:
Net Profit (before taxes) ÷ Net Worth = Return on Investment
Manage Your Profitability and Make Adjustments
Once you’re able to track your profitability and understand the scope of your business’s finances, it’s time to take action against the numbers that weren’t quite hitting your full potential. What action you take will depend greatly on what calculations fell short, but here are a few common adjustments business owners can take to optimize profitability:
- Raise your products’ prices
- Ensure operating costs aren’t increasing
- Boost productivity and efficiency
- Perform more market research and expand your market
- Create more detailed budgets
- Know and focus on your profitable consumers
Get Extra Help with Pinpoint Management
Profitability tracking and management involve keeping track of a lot of moving parts. Financial consulting is one of Pinpoint Management’s customized coaching and business development services that we offer. We’ll break everything down for you with productivity flash reports, profitability flash reports, break-even analysis, and marketing return on investment reports. Contact Pinpoint Management for business and finance consulting today!