People elect to be self employed business owners for a variety of reasons. Some inherit a family business, others may have a passion that they want to turn into a business such as a fitness training business, others just might want to work for themselves and not have a boss, whilst others might want to build out a business that they can then sell at a later date for a capital gain. But no matter what the reason, a key fundamental metric for any SME is profitability. I’ve previously done a video on the difference between cash profit and accounting profit, but in this short video, we’re going to look at what is profit and what are the 5 Key Metrics to Monitor the Health of Your Business.
1. Net Profit Margin – a very simple definition of profit is the amount of money that is left from the income generated from the business activities after paying all the expenses associated with running that business. This simple metric can get complicated with determining accounting profit due to a range of variables such as timing difference between accounting periods, non-cash accounting items such as depreciation, balance sheet transactions, allowable tax deductions and a variety of other items that might come into the accounting profit calculation. Thankfully, accounting profit really only needs to be determined annually in order to lodge your income tax return and is generally done by your accountant who prepares your financial statements. For an SME business owner. They generally don’t need to concern themselves too much with accounting profit, however constant monitoring of Net Profit is critical on a monthly, quarterly and annual basis. The profit trend will show the health of the business, is it declining over the year? Or perhaps it is seasonal and has peaks and troughs throughout the year. Understanding your businesses profit trend is key to addressing any falling profit. Net Profit Margin is simply the net profit over the total revenue amount. For example, if a business’ total revenue is $2 million per annum, and the profit before tax is $200,000 that business has a Profit Margin of 10%.
2. Gross Profit Margin – whereas Net Profit Margin includes all expenses associated with running of the business, Gross Profit Margin look at the profitability of the goods or services sold. Gross Profit is calculated as the sales revenue, less the cost of goods sold, also known as COGS. The GP Margin is the gross profit over the sales revenue. A GP Margin of less than 50% means the goods are costing you more than half of your sales revenue to buy the goods. Typically, the higher the GP Margin the better, but a lower GP Margin is fine if you’re a high sales volume business. If GP Margin is falling, then you’ll need to either increase your sales price to your customers and or decrease your COGS. Many previously successful businesses later failed because their COGS increased significantly. Might be due to foreign exchange movement for example or an overseas increase in price of the raw materials. But the market would not sustain or allow an increase in the sales price, and therefore their GP Margin became negative.
3. Operating Expenses – if sales revenue is constant and GP Margin is constant, but Net Profit is falling, it’s probably due to increasing operating expenses. Often, businesses have a rapid increase in sales volume, need to employ more staff and upscale their business operations to meet the increased sales demand. But if the gearing up of the business is not closely monitored, the increase operational expenses, also known as OPEX, may mean the business is actually losing money on the higher or increased sales revenue. That said, businesses that are in a growth cycle will have to incur increased expenses, such as new equipment or machinery and profit from previous periods, external debt or other financing mechanisms will be used to pay for this increase in upscaling of the business. But the key is to ensure that the total monthly recurring expenses do not exceed your Gross Profit. If it does, you need to review your expenses and see where you can “cut costs”.
4. Profit per Client – some clients will be more profitable than others, and a good business owner segments his client based by profitability. Surprisingly, the highest revenue clients may not be the most profitable clients, depending on the expenses that are incurred in servicing those clients. If your business operates a fixed cost per client model, then yes, the higher the revenue, the higher the profit. But just be aware you may have some clients where your business would be more profitable if you did not sell to those clients.
5. Sales Pipeline – a business is like a furnace that needs to be constantly fed wood to keep burning. Businesses generally have fixed expenses and variable expenses. Fixed expenses are incurred regardless of whether the sales are being made in the business, such as rent and staff payroll. Variable expenses may vary based on your sales volumes such as COGS and marketing expenses. So whilst variable expenses may reduce in times of lower sales, The fixed expenses continue unless employees are made redundant and leases terminated. Therefore, having an eye on your sales pipeline to ensure a constant supply of business fuel that being sales, is critical to the success of any business.