In order to know if your small business is profitable, you need to look at your Income Statement and not your bank account.
Just because you have money in your bank account does not mean that you are profitable.
The Income Statement is a word that is thrown around quite a bit. But what does it mean? And how does it apply to your business?
Let’s start with what makes up an Income Statement.
- Revenue: This is the income you’re receiving from your various sources. For example, if you’re a blogger, your income can be coming from affiliate marketing, advertisements, etc. – all these income sources are REVENUE
- Direct cost: These are costs directly attributable to the business. For example, if you sell printers, the cost associated with purchasing the printers from the manufacturer, freight for shipping the printers, merchant service fees attributable to the sale, etc. are all considered direct costs. Direct costs are correlated to the number of products and services sold. This means that for every printer you sell, your direct cost will go up.
- Gross Profit: In simple terms, this is Revenue minus Direct Cost. This represents how profitable your product or service is.
- Overhead Expense: These are costs not directly attributable to generating revenue. These costs include rent, utilities, salaries for office staff, consulting expenses, etc. Sometimes, if revenue increases, there might not be a need to increase overhead costs and the resources you already have can support the additional revenue.
- Net Income: This is gross profit minus overhead expenses. This the number that matters. It’s a key profitability indicator and tells how much profit you are bringing in. Some industries like financial services and real estate have sky-high profit margins, while others are more conservative.
You can utilize industry standards as a benchmark to see how well you’re performing. Your local chamber of commerce or an industry report online is also a good place to start.
Now that you have a good understanding of the Income Statement, how do you use it to figure out if you are profitable? Here are 4 tips to know if your small business is profitable.
1. Gross Profit should be positive
Gross Profit = Revenue – Direct Costs
This means that the revenue you receive for the product or service should be enough to cover the Direct Costs.
In other words, gross profit is the profit you realize after deducting direct labor, inventory, shipping & fulfillment, etc. It does not consider your overhead expenses
If your gross profit is high, it means you keep a higher profit relative to the cost of your product or service
Gross Profit should not fluctuate drastically from one period to another. If it does, this could be a red flag that should be looked into.
2. Operating Profit should be positive
Operating Profit = Gross Profit – Overhead Expenses
It is also commonly referred to as Earnings before Interest and Tax (EBIT)
This is the residual income that remains after accounting for all costs of the business (both Direct & Overhead costs)
Unlike gross profit, an increase in operating profit illustrates a healthy company
Operating profit shows how efficient your business is running
This is a good number to use if you are benchmarking your returns with other companies in your industry
3. Net Profit Should be positive
Net Profit = Operating Profit – Additional expenses such as taxes, interest payments from loans, one-time expenses, etc
It is also referred to as Profit Margin
It’s similar to Operating Profit, however, it accounts for earnings after all expense obligations
In simple terms, it tells you how much income residue you have after accounting for all cash flows both positive and negative
It’s arguably one of the most important financial metrics that highlight the profitability of a business.
4. Cash Flow Margin
Cash flow margin = Cash flows from operating activities/net sales
The higher the percentage of cash flow, the more cash is available from sales to pay for your expenses
Cash flow margin measures how efficiently a business converts sales into cash
The conversion of sales to cash is vital for business success
A few ways to increase your cash flow margin are: Shortening payment terms of your Accounts Receivables, Paying off your Accounts Payables a bit later on, and holding off/space out making big purchases
One final note, it’s always recommended to review your financial statements often. You’ll want to know if any amounts are off/spot red flags and quickly course correct if needed so that your profitability does not suffer.