Why Small Businesses Need to Be Laser-Focused on Profit Margins
In their quest to grow and become viable, it’s not unusual for many small businesses to become fixated on their revenues and cash flow as a measure of their progress. However, any success they might realize based on revenue and cash flow milestones is likely to be short-lived if the business is not profitable. Even those businesses that measure progress based on profits earned may find themselves hitting a wall at some point in the future. Revenue, cash flow and profits tell you how the business is doing today. However, they tell you very little about the direction of the business and whether its growth is sustainable. The more important indicator of overall health and performance for any business is profit margin.
As an example, consider three companies of varying sizes, each having generated $500,000 of profit. The largest company accomplished it on $10 million of revenue with a profit margin of five percent. The mid-sized company did it on $5 million of revenue with a profit margin of 10%. The smaller business made $500,000 of profit on $2.5 million of revenue with a 20% profit margin.
If you were to measure a company’s performance based on profits, they all achieved the same results. But, when you consider their profit margins, the smaller company had the best performance. You would think that the larger the company and the greater their revenues, the more likely it would survive an economic downturn; but, it is the company with the strongest profit margin acting as a financial buffer that is better positioned to weather a severe storm.
What does your profit margin tell you? Most business owners understand that a profit is what’s left on the bottom line after accounting for all expenses. For many businesses it represents cash available for spending or reinvesting in the business. For sole proprietors or partnerships, it represents the income the business owners can take from the business. So, in that respect, it is important to know what profits are available at any given time. The calculation for net profit is very simple:
Net profit = total revenue – total expenses
To determine whether a business can expect profits in the future, it must use the additional metrics of gross profit margin and net profit margin. Both are important, but they offer slightly different insights into the performance of a business.
Gross profit margin: Gross profit margin is a metric used to measure how well any particular product or group of products is performing. A business can be doing well overall but, if certain products are mispriced or are not performing well in the marketplace, falling gross profit margins can drag the rest of the business down. It may be due to higher-than-expected production costs, or it could be the result of shrinking sales. Either way, by identifying the cause of shrinking gross profit margins, a business can focus directly on the underlying issues to stop the bleeding. To calculate gross profit margin, all of the costs associated with the production of the finished product or delivering of a service are subtracted from the revenue generated from product sales and then divided by the revenue.
Gross profit margin = (revenue – cost of goods sold)/revenue
So, if $500,000 of revenue is generated from product sales and the cost to produce the product is $400,000, the gross profit is $100,000 for a gross profit margin of 20%.
By using a percentage as the key metric, it’s easier for the business to compare its performance to its competitors or industry standards. It’s also more useful in identifying trends and projecting revenue and profits.
Net profit margin: The net profit margin, which is based on a company’s total revenue and operating expenses, provides more of a macro view of a company’s performance. For example, if a company generates $5 million in revenue on $2.5 million of operating expenses, the net profit margin would be 50%.
Net profit margin = net profit/total revenue
Net profit margin, especially when viewed over time, provides a business with an indication of its overall health and whether it is optimizing its output. A declining net profit margin may be an indication that the company is losing ground in the market due to increased competition or a faltering product line. An increasing net profit margin may be an indication of increased market demand and the opportunity for a price increase or to expand into the market. Either way, the net profit margin should be used as a bellwether for the business to track its strategy and make adjustments (i.e. increase sales volume, reduce overhead costs) that will improve it.
Maintaining and growing a strong net profit margin is critical for businesses that may seek financing because it’s an indication of their financial health and ability to withstand downturns. The way lenders evaluate a company’s profit margin is by comparing it with industry averages and direct competitors. Businesses should always know where they stand with their profit margin and what it’s telling them about their future.
You have to know your numbers. “As business owners, we can’t bury our heads in the sand,” say Randy and Arwen Becker of Becker Retirement Group in Bellevue, Washington. “We have to know the numbers to have a true and realistic picture of how effective our marketing activities are.” For an unbiased perspective, Randy and Arwen, who recently signed on as Umpqua Bank business customers, use an outside accounting service to crunch their numbers and help them “microscopically” analyze their activities each month. That exercise enables them to focus on the most profitable ways to deliver their services to the market.
Profit margin is just one indicator of business health. In addition to evaluating profit margins and other key financial metrics, business owners need to be able to assess the overall health and performance of their business, which includes the effectiveness of their strategies, the efficiency of their operations, and their business’s outlook based on financial and market trends, among many other business facets.
Umpqua Bank has harnessed its expertise and resources, developed through more than 60 years of working with small businesses, to offer small business owners a free business review. Each business owner is assigned a team of Small Business Bankers each responsible for covering a different aspect of the business. As Michele Livingston, director of small business at Umpqua Bank, explained in a recent Inc.com article, she and her team work with clients to “peel back the onion” to find issues before they become a problem. If your profit margins are on the wane, the team will not only help you identify the problem, it will work to develop solutions to get them back on track.