This is Part 2 in our “Know Your Numbers” series, which will help you read your financial statements, better understand the numbers that drive your business and ultimately make better decisions.
Once you learn how to calculate your profit in Part 1 of our series, it seems like all it would take to boost your profit is to increase revenue or decrease expenses, right? Well, it’s not quite that simple. Your net profit can be calculated in different ways, therefore, there are different ways to increase that number. Here’s how to do it.
Understand how your accounting method affects your revenue and expense calculations.
Your net profit is your total revenues minus your total expenses for a period of time. Seems simple enough, right? Your revenue and expense numbers vary based on which accounting method you use.
Accounting principles allow you to calculate the financial numbers for your business using a variety of methods. The Generally Accepted Accounting Principles (GAAP), a set of standards that many large and small companies follow to measure financial performance, use the accrual method of accounting. This means that revenues and expenses are recognized when the income is earned and when the expense is incurred.
For example, let’s say you’re a service-based firm that works on a project during April. At the end of the month, you invoice your customer. Revenue under GAAP would be recognized in April. In addition, you may incur expenses for using a subcontractor, equipment or software. Those expenses would be recognized in the same month that the service or tool is used.
CASH BASIS METHOD
Another common method of accounting is the cash basis method. If this method were used in our example above, revenue and expenses would be recognized when you receive the cash from your customer’s payment or when you pay out the cash for the expense you incurred. Small businesses often use the cash basis method when filing their tax returns because you only report and pay taxes on money you actually receive in cash.
Regardless of whether you use the accrual or cash method, your profit is calculated the same way. However, you can see why the method chosen affects your revenue and expenses numbers, and therefore, your profit numbers.
A note about profit percentages: Many businesses look at their net profit percentage as a key indicator of their company’s health. Depending on your industry, this number could be as high as 40-60% (as is the case in many service-based businesses) or as low as 1-5% (as is the case of many retail and distribution businesses). Keep in mind that the percentage is relative and just a guide. A business with a 5% net profit on $10M in sales realizes a profit of $500,000. A business with a 50% net profit on $1M in sales realizes the same profit of $500,000. Both business would be considered healthy from a net profit perspective, even with very different profit margin percentages.
Track your net profits over time.
Once you pick a method of accounting, you can work on developing the back office tools to capture the information you need to track your revenues, expenses and profit. This system serves as the heart of your accounting and provides you with trustworthy financial feedback you can rely on to see patterns over time, including both rear view feedback and forward thinking predictions for what cash flow will look like over the next 4-12 weeks.
As your business matures and as you track your financials over time, you can see the results of certain decisions. For example, you might make a large investment in marketing in March and look back at your financials over the first quarter to see how those expenses reduced your net profit. However, you might begin to see your revenues climb later in the year. When you review your financials over that longer period of time, you see that your marketing spend helped increase your revenues and overall net profit after all. It just took a little time to get there!
Analyze the key drivers that increase your revenue and/or decrease your expenses.
Profitability can often be improved by focusing on a few key financial drivers. For most service-based businesses, the key component is their people: the knowledge workers who deliver value to customers, which leads to more revenue and profits. For a real estate developer, their key component might be the number of doors or tenants they have. After making a big investment in a building with fairly fixed costs, each new tenant helps make up those costs and increase their profit.
KNOW THE STEPS TO INCREASE SUCCESS
If you’re looking for ways to increase your profit, keep these three tips in mind:
- Understand how your accounting method affects your revenue and expense calculations.
- Track your net profits over time.
- Analyze the key drivers that increase your revenue and/or decrease your expenses.
By taking these steps, you’ll be more financially literate and more equipped to take smart steps to grow your net income.
In addition to profits, what other numbers are key performance indicators for your business? Watch for the next installment in our series to find out!
For more information on how to calculate these numbers and use them to make more informed business decisions, get in touch with us.