Most small business owners start a new business because they have a passion or new idea, want to be their own boss, and crave financial stability and higher earning potential. However, making a profit and growing your company distinguish a hobby from a successful business.
You may not have a background in finance or accounting, but understanding your company’s financials is critical for long-term business success. We’ll explore tips for getting a handle on your small business’s finances and explain what you should know about profitable growth.
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Relationship between profitability and growth
Profitability and growth dictate many crucial business decisions. They’re intertwined and co-dependent; both are necessary for any company’s long-term success. You can only continue being profitable if your business grows.
We’ll outline the key differences between profitability and growth and explain their complicated relationship.
Profitability refers to a company’s net profit after expenses. Profit is money in the bank that you’re not putting back into continued operations. Profit goes to shareholders or can be reinvested in growth opportunities, such as product expansion or opening a new location.
Profit may be your company’s only capital if you don’t want to find investors. A business can’t survive for long without a profit. Business financing offers you a chance to gain profitability in the future, but you would need to pay off that debt before your company could look into further growth opportunities.
Growth occurs after a company has reached initial profitability. When a company has made a profit, owners may consider ways to make more money and stay in the black. Although extensive growth beyond profitability may not be critical in a business’s early stages, it should be part of your long-term business goals.
In your business plan, you may include a business growth plan with projections on how and when you plan to grow the company. For example, you may plan to enter new markets, expand product lines, open new locations or franchise the business.
You can measure growth by metrics like your total sales, customer base size, staff size or number of locations.
Growth strategies often include the goal of keeping profitability consistent. Growth can undermine profitability in some instances because of the expenditures required. However, short-term profitability is not a typical business goal. Healthy growth helps a company with long-term capital goals.
Tip: It’s crucial to understand the difference between net income and profit. Net income is the total income after you’ve deducted expenses. Profit is your financial gain after covering expenses, taxes and other costs.
How to achieve profitable growth
Companies must be proactive to achieve growth and profitability. Here are a few ways your business can achieve profitability through growth strategies:
- Increase your market share. Entering new markets is usually the first way a company seeks growth. You may want to test products and services in a new market. For example, if you currently serve customers in Eastern states, you could consider expanding services west. However, it’s best to prioritize profitable, fast-growing markets.
- Introduce new products and services. Increasing your offerings is another way to expand. With this growth strategy, you can satisfy current clients and attract new ones. Before expanding, ensure your core products and services are in excellent shape, and then look to complementary products and services you can offer to the same or similar customers.
- Merge with or acquire another organization. Mergers are a common way for companies to grow within their industries. For example, if you run a successful IT service, you could merge with anther company to increase your profits.
- Open a new location. You could launch new stores or branches to increase your customer base. If your offering’s benefits and appeal aren’t tied to your local region, consider expanding your reach to other regions.
- Bolster your organic growth with strategic acquisitions. Acquisitions give you instant growth in customers, locations and reach. Use them to cross-promote and reach new markets.
FYI: When handling internal communications during a merger, create a merger and acquisition letter for your staff that announces the changes, explains why you’re making the move, and addresses anticipated questions and concerns.
What to know about achieving profitable growth
Achieving profitable growth is a hard-won goal that can be challenging. Keep the following advice in mind on your road to profitable growth.
1. Revenues are not profits.
Contrary to popular opinion, sales alone do not drive profitable growth. Increasing sales is only one part of the equation. Your ability to manage production and operating costs is the other part.
Your revenue is the money your business brings in from the sale of goods and services. Profits are what’s left over on your profit-and-loss statement after subtracting taxes, interest, and the necessary fixed and variable business expenses related to running the business and creating its products and services.
It’s possible to increase your sales but experience a profit decline. This can occur under the following circumstances:
- Your sales increase comes from higher sales of low-margin items while you suffer a decrease in sales of high-margin products.
- The cost to produce your product rises more than your revenue.
- Your operating expenses erode the revenue generated from product and service sales.
A successful company typically grows its customer base and revenue over time to offset increased operational costs. You must look beyond revenue to evaluate your business’s profitability.
Bottom Line: When expanding your revenue sources, stay with something adjacent to your core business. That way, you can leverage your competencies in the growth area.
2. Line-item profits can be more revealing than bottom-line profits.
Most small businesses focus on their bottom-line net profit to measure their success during the year. However, that doesn’t give a clear picture of what’s happening in the business. Many small businesses can’t identify which of their product offerings or customers are profitable. That means they’re making decisions about what to sell, to which customers, at what price and with what resources based on limited information.
You must examine the contribution each product line or service makes to the bottom line. Break out your sales by product line and service and compare them year over year. Do you have any products that are losing sales? Certain key customers may be ordering less, there may be product quality issues or pricing could be out of line.
While many costs can’t be attributed to any one product, allocate your sales costs and as many operating expenses as you can to each product. Are any products generating losses? It may be time to consider revamping the product or product creation process to make it more appealing to customers or retire that product entirely.
Did you know? Common mistakes can lead to product failure, including not validating a need for your offering, not having a sales funnel in place, and not testing the product for quality and usability.
3. Margins are the yardstick of profitability.
The real tool for evaluating profit isn’t a dollar number; it’s a profit margin percentage. Profit margins can tell you the following:
- Whether products are priced and promoted to drive profitable growth: Your small business likely offers products in various price ranges. Are you selling more low-priced products than high-priced ones? It could be that your higher-priced products are not priced effectively (relative to the market).
- Whether all products and services offered are profitable: Most businesses will have a mix of different products and/or services. Do you know which products are more profitable? Two or three products may be propping up one or more unprofitable products.
- The value of each customer relationship: Every business has customers who require more handholding and maintenance than others. Do you know whether the cost of doing business with those customers is worth the revenue they bring in, given the time and attention you spend on them? Is your attention better spent on business development, for instance?
- Whether resources are allocated efficiently: Profit margins are an indicator of whether or not you’re spending money in the right areas of the business that directly impact the bottom line. What is the time and resource cost for each product or service? What are your marketing costs versus your marketing ROI?
4. You can’t rely on financial software programs alone.
Many small businesses rely on the best accounting and invoicing software to track their financial data. While these programs are excellent tools, they have some downsides, including the following:
- Financial software doesn’t tell the whole story. Financial software tools don’t present a comprehensive picture of your finances to help you assess your business’s health. While you can run reports, you’ll need to hire a CPA or gather a finance team to help you understand them. Is your accounts receivable turnover low? Some of your customers may not be paying you on time. Has your gross profit margin been declining over the past six months? That could signify that it’s time to start talking to your materials suppliers about better terms.
- Financial software doesn’t explain your growth strategy. Financial software tools don’t give your small business an edge in determining your market and business growth strategy. Do you know where you should focus your marketing dollars? Can you decide where to achieve cost savings? Do you have enough cash flow through the end of the year? Software alone can’t answer those questions.
- Financial software is only as accurate as your input. Financial software tools don’t automatically provide accuracy and can’t evaluate possible gaps as a skilled bookkeeper can. Are you reconciling your books monthly? Do you know how to categorize every business expense? Are you familiar with accounting principles for your unique business or industry?
Qualified bookkeepers or financial professionals will understand the latest accounting policies, produce accurate books, ensure compliance with IRS methods, and provide business consulting and advice. It’s also a good idea to have an accountant review your books at least annually to advise you on financial strategy.
Your valuable time can be better spent making informed decisions to grow your business instead of wrangling receipts, accumulating data, formatting spreadsheets and calculating ratios.
Set up your business for profitable growth
Most business owners plan for growth, but not all will create a plan that effectively ensures profitable growth. Growing your sales while focusing on profit margins can help your business find long-term success. And consulting expert financial professionals can keep you on the right path to profitable growth.
Jennifer Dublino contributed to the reporting and writing in this article.