Here's how to understand if your business's growth is profitable.
Most small business owners start their own business because they have a passion or new idea for something, want to be their own boss, or are seeking more financial stability and/or earning potential. However, very few entrepreneurs have an accounting or finance background.
In a 2015 Intuit survey, only 40% of small business owners considered themselves "extremely" or "very" knowledgeable about accounting and finance. Sound familiar?
Even though you might not have a financial background, you can get a handle on your small business's finances by evaluating your venture regularly. Here are four tips to get you on the right track.
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Relationship between profitability and growth
Profitability and growth are two factors that dictate many key business decisions. Both are necessary for the long-term success of any company, and they are each essential for the other one to occur. You can only continue being profitable if your business grows. Here are the differences between profitability and growth, as well as their complicated relationship to one another.
Profitability refers to a company's net profit after expenses. In the simplest of terms, profit is money in the bank that is not being put back into continued operations. Profit goes to shareholders or can be reinvested in growth opportunities, such as product expansion or a new location. Profit may be your company's only capital if you don't have investors. A business can't survive for long without a profit. Business financing offers you the 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 your company has made a profit, you can think of ways to make more and stay in the black. Although extensive growth beyond profitability may not be important in the early stages of a business, it should be part of your long-term goals. In your business plan, you may have projections on how and when you plan to grow your company, such as entering new markets, expanding product lines, opening new locations, and franchising. You can measure growth by metrics such as your total sales, number of staff or number of locations.
Growth strategies often include the goal to keep profitability consistent. However, growth can undermine profitability in some instances. According to a study published in the International Journal of Hospitality Management, profit creates growth, but growth can hurt profitability. The 2011 study found that growth in the restaurant industry impeded profitability. In the same year that restaurants grew, profitability decreased. However, short-term profitability is not a typical business goal. Growth helps a company with long-term capital goals.
Tips for growth and profitability
Companies need to be proactive in order to achieve both growth and profitability. These are some ways a company can achieve profitability through growth strategies:
- Increase your market share. Entering new markets is usually the first way a company looks to grow. You may want to test products and services in a new market. For instance, if you currently serve customers in Eastern states, you could consider expanding services west.
- Introduce new products and services. Another way your business could expand is by increasing your offerings. With this growth strategy, you can both satisfy current clients and attract new ones.
- 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 another company to increase your profit shares.
- Open a new location. You could launch new stores or branches as a way to increase your customer base.
Keep these overarching tips in mind as you carry out your profit and growth strategies.
1. Revenues are not profits.
Contrary to popular opinion, sales alone do not drive profitable growth. That is only one part of the equation. Your ability to manage production and operating costs is the other part. Revenues are the monies your business brings in from the sale of goods and services. Profits are what's left over after all the expenses to run the business, create the products and services, and pay taxes and interest are taken out of revenues.
It's possible to increase your sales but experience a profit decline. This can occur if ...
- 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 revenues.
- Your operating expenses erode the revenues generated from product and service sales.
A successful company typically grows its customer base and revenue over time to offset increased operational costs. You need to look beyond the revenues to evaluate your business's profitability.
2. Line-item profits can be more revealing than bottom-line profits.
Most small businesses focus on their bottom-line net profit as a measure of their success during the year. However, that doesn't give a clear picture of what is happening in the business. Many small businesses can't identify which of their product offerings or customers are profitable. That means they are making decisions about what to sell, to which customers, at what price and with what resources based on limited information.
You need to look at 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, or pricing could be out of line.
While many costs cannot be attributed to any one product, allocate your costs of sales and as many operating expenses as you can to each product. Are any products generating losses? It may be time to consider ways to revamp the product to make it more appealing to customers or retire that product entirely.
3. Margins are the yardstick of profitability.
The real tool for evaluating profit is not 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 high-, medium- and low-priced products. 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 product and services offered are profitable. In most businesses, there will be a mix of different products and 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 of your customer relationships. 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 are 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 ROI?
4. You can't rely on financial software programs alone.
In this age of do-it-yourself and software efficiencies, many small businesses have come to rely on accounting and bookkeeping software programs to keep track of their financial data.
While these programs are great at tracking numbers ...
- They don't give you a clear picture of your finances to help you assess the health of your small business. While you can run many reports from a software program, you'll still need someone with experience in finance to help you understand what those reports mean. Did you notice that your accounts receivable turnover is low? That could be a signal that some of your customers aren't paying you on time. Has your gross profit margin been declining over the past six months? That could be a sign that it's time to start talking to your materials suppliers about better terms.
They 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 you can achieve cost savings? Do you have enough cash flow through the end of the year? Software alone can't answer those questions.
- They don't automatically provide accuracy, nor can they evaluate possible gaps as a skilled human bookkeeper can. Are you reconciling your books each month? Do you know how to categorize every business expense? Are you familiar with accounting principles for your unique business and/or industry? It makes a lot more sense to let a bookkeeper do the heavy financial lifting for your small business. A qualified bookkeeper who is knowledgeable in finance keeps up with the latest accounting policies, produces accurate books, ensures compliance with IRS methods, and provides business consulting and advice. Your valuable time can be better spent making informed decisions to grow your business than wrangling receipts, accumulating data, formatting spreadsheets and calculating ratios.