“Without an understanding of profitability, every business, no matter how successful is a house of cards” – Mike Michalowicz, Entrepreneur and Author.
There are four ways you can improve your profits: sell more, get customers to buy more frequently, increase margins and reduce costs. If you can do all four at once, your profits will increase dramatically. Even changing one of these four factors will boost your profits.
In this article, we will cover the main reasons for low profits and how a part-time CFO will help you to boost your profits.
Profits are vital for your company’s growth for the following reasons:
- They provide a return on your investment capital.
- They provide opportunities to reward staff.
- They make it easier to attract investors and customers.
- They make it easier to borrow money and negotiate a lower interest rate on the money it secures.
- They can be reinvested in the business to expand into new markets, products and locations.
- They provide a buffer against economic downturns and changes in market conditions.
- They make it possible to hire more people.
- They allow you to develop and test new products or services.
While many business owners experience a decline in their net profit margin (the percentage of total revenue that’s profit) at one time or another, they are usually able to continue to trade, albeit with the aid of a short-term loan and some heavy duty cost-cutting.
Sadly, unless you identify and address what’s causing your profits to shrink, the problems are likely to get worse. For it often follows that poor profitability leads to reduced cash flow. When profits are low and cash flow is weak, businesses can slip into a downward spiral.
Your profits tell you how well or how poorly your business is performing. For example:
- Gross profit (the total amount your business makes minus the cost of goods sold (COGS) indicates how efficiently your business uses resources to produce your products or services.
- Operating profit (gross profit minus operating expenses, depreciation,and amortization) indicates how efficiently you produce and sell your product or service.
- Net profit (the amount of money left after paying all the business’ expenses including interest, taxation, etc.) indicates how well your business is generating healthy results.
These figures alone won’t give you the whole picture. You’ll need to compare them with previous annual and monthly profit results. That’s where ratios come in: they can be used as a benchmark against which you can measure your business’ performance.
Profitability ratios help you evaluate your company’s ability to generate profits.
They include gross profit margin; operating profit margin; and net profit margin.
- Gross profit margin – your gross profit divided by your sales is a useful indicator of your company’s financial health. It shows how efficiently your business is using its materials and labour in the production process and gives an indication of the pricing, cost structure and production efficiency of your business. The higher the gross profit margin, the better. That is because the higher the percentage, the more your business retains of each dollar of sales, which means more money for other operating expenses and net profit.
- Operating profit margin – calculated by dividing your operating income by your net sales during a period reveals how much revenues are left over after all your company’s variable or operating costs have been paid. It also shows what proportion of revenues is available to cover non-operating costs like tax, interest, and distribution to your company’s owner. It is useful because it shows you whether your operating costs are too high.
- Net profit margin – calculated by dividing your after- tax net income (net profits) by your sales (revenue) shows the amount of each sales dollar left over after all expenses have been paid. The higher your net profit margin, the better because that shows your company is more efficient at converting sales into actual profit. A low net profit margin might mean that your business is not generating enough sales, your gross profit margin is too low or that your operating expenses are too high.
The main reasons for low profits
Your sales or revenue slump could be due to internal and external factors such as:
- Inadequate marketing programs. To be effective, your marketing needs to convey the right message to the right target audience and convince them to take a desired action like call your company to purchase a product or book your service.
- Poor pricing strategies.
- Increased competition.
- An inability to keep up with market changes.
Budget overruns or unexpected costs will chip away at your net profit.
High variable costs
The higher your variable costs, the lower your net profit margin will be. High production costs or purchase costs can result in insufficient funds to cover expenses. When variable costs rise to the point that there are not enough funds left to support all expenses for the period, a net loss will occur.
Follow us in part II of the profit improvement article to learn how a Part-time CFO can help you drive profitable growth! Coming up soon.