Small business owners constantly look at the top line of their financial report to see how well they’re doing. We’re taught that the number one way to grow a business is to sell more. As the marketing expert, Gary Vaynerchuck, often says … “offense always solves problems”.
However, I think it’s more important for long-term success to pay attention to the bottom line. With few exceptions, businesses don’t grow without producing profits. In fact, profit is the sole purpose of a business. Managing profit well requires understanding just 3 numbers on your financial statement.
Before you continue reading, there are two thing you should know. First: I hate, hate, absolutely hate to use jargon and abbreviations in my writing. Second: this article uses some jargon and abbreviations. Since it can’t be avoided when discussing financial reporting, I’ve included definitions of the terms & abbreviations as they appear.
On even the simplest P&L statement (profit and loss), you’ll find three different types of profit. Each of these numbers provides specific information that you can use immediately to advance your business goals. Here’s a simple how-to guide for using that data to grow your business.
Gross Profit
What’s included in the number
Gross income minus the costs of selling your product. That’s every dollar generated from selling your stuff, usually called “sales” or “gross income”, and every dollar spent directly on making and delivering the stuff you sell to the customer – called “COGS” (the abbreviation for cost of goods sold).
If you make a physical product, COGS includes all the elements required to produce it – like raw material, equipment operating costs, and incremental labor. A service business is more likely to label these costs as COS (cost of sales) which includes the direct labor cost of performing the service, as well as any parts or supplies used.
What it tells you
Gross Profit is a key indicator for how well you’re pricing the product or service. If this number is not moving in the same direction as your sales – either your prices are too low to cover your production costs, or too high to attract new business.
Operating Profit
(also known as EBITDA)
What’s included in the number
The gross profit minus all operating expenses. Operating Profit is what’s left over after you’ve paid the costs of keeping the doors open and the lights on – this is informally known as overhead. Overhead includes everything from insurance to office supplies, as well as the costs of employees not already counted in COGS.
Note: The abbreviation “EBITDA” is why you never should let your accountant run the business. Its use originated in the tax & securities compliance world and has been, unfortunately, adopted by people who like to sound smart. Small businesses that don’t trade their stock on the public markets should stick with the term operating profit.
What it tells you
Operating Profit tells you how healthy your business is. If you’re overspending relative to the size of your business, it’ll be evident. Overhead is where a business owner can make the greatest impact because so many of those types of costs can be negotiated. If your rent is too high, move. If you’re paying too many people who are not directly producing revenue, outsource.
If you look at COGS as the money you have to spend, then overhead is the money you have to save.
Net Profit
What’s included in the number
The operating profit minus interest expense, taxes, depreciation, and amortization. This is your take-home money. There are costs unique to your business structure that aren’t counted in either COGS or overhead because they’re not technically operating expenses. Rather, they represent the cost of capital. To understand this number, you don’t need to get caught up in the various types of assets or worry about tax strategy. Look at these costs as “rent” you’re paying on your business resources. It’s the cost of ownership.
What it tells you
Simply put, Net Profit is the return on your investment. Growing your Net Profit is the same as earning better returns from stock or real estate investments. We all want our money to work for us, right? So, why aren’t we happy with an annual ROI of 5% or 10%? Because we think we can get 15% or 20%.
The net profit tells you how well your financial strategy is working. If it’s too low, you may need to learn more about managing capital. Or you need to hire the right people who can do it for you. Net Profit is your final report card.
And that’s how to use 3 numbers to maintain focus on business growth. Go get it!
