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Here’s an example: Alex owns a custom framing shop with low prices, just above cost, to attract customers. The volume helped maintain revenue. One wall of the shop was dedicated to the artist’s paintings, for which Alex received a percentage of the sale. Until a stationery store opened down the block, Alex was the only person in the area offering custom frames. In addition to pens and printer paper, the stationery store has dedicated a corner to personalized frames at 20% less than what Alex charges. Alex immediately put a large sign in the window promoting the same price as the stationery shop and ended the month in the red.
You probably recognize that Alex’s mistake was to change prices without evaluating how it would affect profitability. It didn’t help that Alex didn’t know if the frame shop was profitable to begin with.
Alex’s reactive pricing decision is one of many a company faces every day. A contractor must decide the number of workers to onboard. A growing business today can be offered a lot in the way of production equipment for cash. In these cases, there may not be time to do the math to make a decision.
Related: Why this metric should be prioritized over growth for startup success
How is profit determined?
Your profit is the amount you have left after accounting for the costs of running your business. It’s different from your income. Here it is expressed as a formula: total revenue – total expenses = profit.
Total revenue is all the money that comes into your business. For Alex’s business this is the money paid for framing plus the money received as a percentage of the paintings hanging on the wall. If framing brought in $84,000 and painting commissions brought in $24,000, Alex’s income for the year would be $108,000.
Alex’s total expenses include materials needed for framing, shop rent, utilities and supplies. These amount to $96,000 for the year. Using the basic formula, $108,000 – $96,000 = $12,000 in profit.
There isn’t much room for maneuver. A 20% drop in framing revenue means annual revenue of $67,200; with painting fees, you’re looking at $91,200. If expenses do not change, Alex’s frame shop is now unprofitable to the tune of $4,800.
What lets you know your profitability?
Before new competition arrived, all Alex knew was that the framing company paid its bills with a little leftover. When the market changed, Alex had to decide how to react.
Knowing exactly where the store was could have changed Alex’s decision. He may have chosen to reduce prices by only 10% – or not at all – or he may have been looking for a way to reduce expenses, such as finding less expensive space to rent.
Knowing the profitability of any business allows the owner to react quickly. This can be the difference between profit and loss, as in the case above, or it can add profit. For example, knowing that there was a $1,000 profit each month might have prompted Alex to rent a stall at a farmer’s market for $100 a month, which might have resulted in extra business worth $500, or he could have put more paintings in the shop. on sale.
Business circumstances change and revenue opportunities present themselves at any time. Not all decisions need to be made in a split second. However, if you Candies create one quickly, it can make or break your business. This can also be important if you have applied for a loan for your business. If your profitability is different from what you presented to your bank, this could affect the terms of the loan or the interest rate. If your profit is lower than expected due to the cost of the materials needed, you can find a new seller.
Related: Don’t File and Forget: Use Receipts to Get Business Spending Insights
How do you know if you are profitable?
To get a complete picture of your condition, consider using the following tools:
- Income statement (or income statement). The basic calculations for this have been explained above, but there can be numerous items that go into your profit and loss statement. If you know them now, you can make a decision now.
- Cash flow statement. A cash flow statement focuses on liquidity. In Alex’s frame shop example, let’s assume that the commission on paintings is only paid once a year. Alex would remain in the red for much of the year. The essential formula is:
- Cash inflow – cash outflow = net cash flow. Cash inflow is any source of incoming money; sales are the most important. Cash outflow is any source of outgoing money such as rent, utilities, and taxes.
- Income/expense analysis. Add up your income and expenses in one period (for example, this month) and compare them with another period (for example, the previous month or a year ago). You’ll see if your business is making progress and what effect your expenses are having on your income.
Real-time metrics for business health
The only way to know if your business is profitable at any time is to keep tabs on your accounting. Alex wanted to frame art, but soon learned that it was necessary to keep books. The traditional way to do this was to record each transaction in a journal. A more modern way is a spreadsheet. Cloud-based storage can help, and there are storage options from all the major digital players. The most modern way to track your business is a document management system (DMS), which can capture data in multiple ways and store it in the cloud for access from multiple locations.
Timeliness and accuracy are key. Decide when you will do the accounting and don’t deviate from your schedule. Be thorough; Double-check your entries and calculations (especially with a spreadsheet). You’ll be glad you did when you make a key decision. If you think you need data at a moment’s notice, do accounting frequently.
Related: Want Taxes to Be Easy? Work on it all year round, not at the last minute.
Now is your time
Banks can apply for loans, businesses can fail, competitors can open, consumer demands can change, the perfect store can become available, a complementary business can be offered for sale at a great price – all of this can happen to your activities at any time. Knowing that your business is profitable enough to respond appropriately is the path to success. Just do it. Now.