Understanding Profits

Many small business owners believe that as long as they’re making a profit, they’re doing well. However, they often find themselves struggling financially down the line. Focusing solely on profit can lead to short-term gains, but it can also create long-term issues.

When I hear the phrase “I’m making profits,” I often wonder what profits the business owner is referring to. Measuring profits takes many forms. It’s essential to differentiate between various types of profit to truly understand your business’s health.

As a small business owner, your goal should be to achieve sustainable profits…… those that are consistent, well-managed, and don’t compromise relationships or quality. The first step to sustainable profits is understanding the different types of profit. Not all profits are created equal, and each one impacts your business differently but together, they drive your business's overall success.

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Gross Profit

Gross profit, in its simplest terms, is the selling price of your goods or services minus the cost price. The selling price is the amount you charge your customers before adding any taxes and surcharges like VAT and delivery fees.

To determine your selling price, you first need to understand all the costs involved in bringing your goods or services to market. For products, these costs include the purchase price of the goods, shipping fees, customs charges, packaging, and other expenses directly associated with getting your product ready for sale. If you are in the service industry, the same principle applies. Although you may not have raw materials, consider all the activities and expenses incurred to make your service sellable or transferable, such as labor, technology, transportation, administrative costs and your time. Once you have these costs, you can add a markup to set your selling price.

Markup is the amount added to the cost price to ensure a profit. It covers not just the direct costs but also contributes to covering your overheads that are not directly related to the selling price of the goods or services and an excess that will be considered your gross profit. For example, if your cost price is $50 and you add a $20 markup, your selling price becomes $70. Your gross profit in this case would be $20 ($70 selling price - $50 cost price).

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A healthy gross profit indicates that you are effectively covering your costs and generating sufficient revenue to contribute to other business expenses and still have excess.

A common profitability ratio to check the health of your gross profit is known as the Gross Profit Margin (GP Margin). It shows how much money remains from your sales after covering the cost of producing your goods or services. The GP Margin is usually expressed as a percentage of your sales. A higher GP margin indicates that your price is sufficiently set to cover your direct costs.

Using the example above, the GP Margin would be calculated as follows: Your gross profit of $20 divided by your sales of $70, multiplied by 100 to get the percentage, which results in approximately 28%.

GP / Sales x 100 = $20 / $70 x 100 = 28%

Net Profit

Beyond the costs directly tied to making a sale, businesses face various expenses that impact their profitability. These costs can be recurring, like rent, telephone bills, and professional fees, or one-time expenses such as marketing campaigns or process improvements requiring consultant fees. The nature of these costs depends on your business model. The key is to ensure every expense contributes positively to your business… whether it supports growth, aligns with your business’ purpose, ensures compliance, or improves efficiency.

Some costs are straightforward cash expenses, while others, like depreciation (written down value on assets) or provisions for uncertain payments, affect profitability but aren’t immediately paid out. Taxes are also obligatory costs that impact your bottom line.

Net profit is what remains after deducting all these expenses from your gross profit. It’s a crucial measure of your business’ true financial health and sustainability.

In the earlier example, where the business had a gross profit margin of 28% ($20 in gross profit), if the total incurred costs, both cash, and non-cash, exceed $20, the business will not show a net profit but will show a loss.

Profit Before Tax and Depreciation

Another key metric that small businesses should pay attention to is their profits before tax and depreciation. This metric provides a clear picture of your business' operational efficiency. It allows you to see how much money your business is generating from its operations before considering external factors like taxes. It is valuable for making strategic decisions, such as reinvesting profits into growth initiatives, optimizing expenses, or planning for future tax liabilities.

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Profit is essential, but true financial health lies in understanding all costs and their impacts. SMEs must make a point to grasp all profit variables.

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Without a doubt, being profitable is essential, but true financial health comes from understanding all your costs and their impact. Simply put, knowing which profits to focus on and understanding the effect of all variables is crucial. For instance, (using the example above) if your business shows a gross profit (GP) margin of 28%, you might initially celebrate. However, a deeper look is necessary…. ask yourself if the remaining $20 is truly sufficient to sustain your business.

If the answer is no, it's time to revisit your strategy from all angles.

Evaluating your profitability isn't a one-size-fits-all approach, nor is it a straight path. Understanding what each profit metric means for your business helps you spot potential shortfalls before they become major issues. And if you're already facing challenges, knowing where to start making adjustments is key to the recovery process.

The views reflected in this newsletter are those of the author and do not necessarily reflect those of Aegis Business Solutions, its partners, or any affiliated companies.

Thank you for reading! If you found value in this article, consider sharing it with your network. In the next issue, we’ll share some tips to help you assess your profitability and the key metrics and practices you should adopt.

Have a specific topic in mind you'd like me to cover? Feel free to message me. Until then, here's to your continued success! ??