Last week I introduced you to a 3-part financial framework I’m working on called PCFEV (Profit – Cash Flow – Enterprise Value). Ok, the name needs some work.
Anyways, if you missed that, you can read it here.
This week, I’m going to break down the first leg of the framework… Profit.
Profit is at the same time understood and misunderstood in the business finance world.
Often, when you talk profit, people assume you’re talking about cash in the door.
Other times, they assume EBITDA or Operating Profit over true Net Profit.
So, what is profit?
Net Profit is the value generated from your business after sales and expenses are accounted for. Other terms you’ll here are “Net Income” and “Earnings.”
For a business to be successful, you have to generate profit. Sure there are fringe cases where that’s not true, but we aren’t here to talk about fringe cases.
To get to profit, you need to understand the Income Statement.
The Income Statement formula is: Revenue – Expenses = Profit
If you want more specifics about what Revenue or Expenses are, go to my resource here and read about it.
When evaluating profit, there are a few things to consider:
- What is driving profit?
- What will help us generate more profit?
- What expenses are required to support profit?
- What should our expected profit percentage (margin) be?
- Are we generating enough profit to support the business and its owners?
Let’s break these down.
What is driving profit?
Profit starts with Revenue from the top line of the Income Statement. Revenue is a summation of all the sales you have.
Slight changes in revenue can drastically change your profit.
For example, if you sell $100 in services (recorded as revenue) and have $70 in monthly subscriptions, you make $30 in profit (assuming no other expenses). But if that $100 in services was only 2 sales and you lose one the next month, that $30 in profit turns into a $20 loss.
When you have fixed or overhead expenses, it’s important that revenue be sufficient to cover these overhead expenses even in the worst of downturns. This is rarely the case, which is why businesses have to layoff people and make cuts when things go wrong.
So, by understanding what’s driving profit (and thus understanding your revenue), you can better look for warning signs of revenue faltering.
What will help us generate more profit?
In some ways, this is an extension of the last question, but it’s important enough it requires its own point.
When you intimately understand your revenue, you’re better able to dissect your revenue streams and know:
- what buttons to push to grow it
- when to hit the “eject” button on a stream
Either of these things can generate more profit.
If you see a stream that is underutilized or not reaching market potential, you can give that stream the attention you need to grow it. This can be through resources such as equipment, inventory, or even sales & marketing. This grows topline revenue, which with profitable products grows our profit.
When you’re losing money on a stream, or a market is shrinking, understanding your revenue allows you to pull out quicker than other companies might.
When “ejecting” out of a bad revenue stream, we’re stopping losses, which allows your profitable streams to carry through to the bottom line profit.
I’ll add, as a caveat, you may make decisions here that hurt short-term profit, but grow long-term profit and ultimately help the company become healthier.
What expenses are required to support profit?
In the same way that the 2nd question builds on the first, this question builds on the 2nd. When we talk about expenses that support profit, we’re talking about both cost of goods sold and overhead expenses.
First, we want to deeply understand the Gross Margins by each product and/or service line.
Second, you need to understand the indirect costs associated with running a business like the one you have.
When you have a deep understanding of cost of goods sold and indirect expenses, you can act quickly when things don’t go as you expect them to.
It’s easy to hyperfocus on expense correction, but this is always a temporary solution. First, you can only cut so much. At some point, the cutting starts to hurt the business. Second, a focus on cutting doesn’t leave room for a focus on growing revenue.
What should our expected profit percentage (margin) be?
Every company should have a profit margin goal. Your goal will be affected by a few things:
- Industry averages
- Company stage/size
- Owner’s preferences
By having a goal, you’re able to look quickly at your financials and see if you met your goal and where you’re trending. It’s one of the easiest metrics to monitor and can be extremely telling of a company’s health.
Some may look at EBITDA or other similar metrics, but as long as you’re consistent it doesn’t matter.
While I can’t give you a number, I can pose this question: what profit margin would be more attractive than your other alternatives?
Money deployed in your business is an investment and there are plenty of vehicles to get a return on investment. Real estate, the stock market, just to name a few. No business should run as a charity, so your profit margin goal should be set so that you maximize your return, even compared to other asset classes.
Are we generating enough profit to support the business and its owners?
Each business operates by the rules the business owner sets. As a business owner, you need to have a concrete vision for what you’re trying to achieve.
If it’s growth at all costs, profit might not be a focus (and you’ll focus on revenue instead).
If it’s your standard of living, profit might be the most important metric of all (along with cash flow).
This is extremely personal and an area I can’t give you a prescriptive answer. But, I would say we should think of this in terms of building the owner’s wealth and cash flow. Ask: what wealth and/or cash flow goals does the owner have and how is this profit helping them achieve them?
We’ll talk about this more next week, when we talk about cash flow.
Bringing it home
Once we have a deep understanding of these questions, we can use these answers to identify 2-3 KPIs that we want to establish. Some examples of KPIs that could be used here:
- Revenue Growth
- Gross Margin
- Gross Margin Trend
- Overhead Burden
- Profit Margin
- Profit Margin Trend
- Units sold
While we’re digging in here more than we did last week, I’ll acknowledge much of this is still surface-level.
To go deeper with this, and the other concepts from this framework, I’d encourage you to join my cohort. Classes start on October 17th. It was brought to my attention that the discount code EMAILCREW wasn’t giving $250 off, so I’ll give you a second chance… Until Sunday, October 2nd at 11:59pm EST, the code will be active. After that, your only option is joining at full price.
If you want to better understand financial statements, here are 3 ways I can help: