Is your business as profitable as you want it to be? And what is the best way to assess whether it is as profitable as it should be?
It is very easy to get lost in the weeds as you diagnose (then work on fixing) any profitability problems you might have in your business. For example, when you begin assessing your profitability, you will have lots of questions run through your head. Questions like:
- Could I be more profitable?
- By how much?
- Says who?
- Based on what?
- Do I have a revenue problem?
- Do I have an expense problem?
- Should I raise my prices?
I have found that the best way to answer those questions is to use what I call the 5-minute profitability assessment.
Create the 5-Minute Profitability Assessment (to determine what your profitability should be).
The purpose of the 5-minute profitability assessment is to quickly determine if your business is as profitable as it should be.
For example, in one company the owner was frustrated because cash was always tight despite the fact that they had made big strides in becoming profitable over the last two years. After completing the analysis, it turns out that profits were only 4% of sales in a business where the norm is closer to 10%. At $4,000,000 in revenues, that meant their Profitability Gap was $240,000 (10% – 4% x $4,000,000).
Now that they had put a number on the profit improvement target (the opportunity), the mission became “closing the profitability gap”.
The goal of this 5-minute profitability assessment is to come up with an estimate of what your annual profit should be (or could be). Your estimate doesn’t have to be right. It just needs to be a number you can write down. You will have plenty of time later to explore your estimate in more detail to determine if it should become your new profitability target.
Here’s the exercise. Take 5 minutes to come up with an estimate of how much money you should make each year in your business. Here are the steps:
- Look at your pre-tax income (your profit before income taxes) for the last twelve months. Divide that number by your revenues (total sales). Jot that percentage down. Let’s say that revenues are $10,000,000 and pre-tax profit is $500,000. So the percentage is 5%.
- Look at your gross margin (gross profit dollars divided by revenues). Use that percentage to lookup your pre-tax profit target range in the chart below. Let’s say gross profit is $4,200,000. So the gross margin is 42%. The pre-tax profit range in the table is 15% to 20% of revenues.
- Pick a pre-tax profit percentage in the range and multiply that times revenues. Write that number down. In my example, I’ll choose 15% (to be conservative). That number times $10,000,000 in revenues is a pre-tax profit target of $1,500,000.
In this exercise, based on my example, the profit target is $1,500,000 and the actual profit is $500,000. The Profitability Gap is the difference, or $1,000,000.
Remember, it’s just an estimate… for now. You will have time to more fully analyze that number later.
Give it a try with your P&L.
Philip Campbell is a CPA, financial consultant, and author of the book A Quick Start Guide to Financial Forecasting: Discover the Secret to Driving Growth, Profitability, and Cash Flow and the book Never Run Out of Cash: The 10 Cash Flow Rules You Can’t Afford to Ignore. He is also the author of a number of online courses including Understanding Your Cash Flow – In Less Than 10 Minutes. His books, articles, blog and online courses provide an easy-to-understand, step-by-step guide for entrepreneurs and business owners who want to create financial health, wealth, and freedom in business.
Philip’s 30 year career includes the acquisition or sale of 33 companies (and counting) and an IPO on the New York Stock Exchange.
This book provides a straightforward, easy-to-understand guide to one of the most powerful financial tools in business: a reliable financial forecast. It will transform the financial future of your company and help you make better, faster, smarter financial decisions.
Too many entrepreneurs and CEOs today are feeling more like passengers than drivers in their business. They’re staring at their rearview mirror as they bounce along in the passenger seat. Their company is careening along on the highway of business as they wonder and worry about where their business might end up financially.
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What if you had answers to questions like:
What’s about to happen to my profitability and cash flow?
How much cash can we distribute to the owners of the business?
How long will it take to pay off our debt?
What will our taxable income be this year?
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Put yourself in the driver’s seat of your business by tapping into the unique and exciting benefits that financial forecasting can unlock for you.
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