Mastering the Fundamentals of Profit to Build a Sustainable and Profitable Business

At its core, successful business management comes down to being more proactive and less reactive in managing your business operations at a profit.  Knowing your sources of cash coming in, then following the flow of your money through your business tells you whether your operations are making or losing money.  Failure to know where your money is being spent likely means you are losing money.

The key to achieving business sustainability and profitability is found in the following five concepts:

• Business profits occur at three levels in your business.
• You need both cash and profit management practices to make money.
• There are at least thirteen terms related to achieving business profitability, you should
• Why do I always want to have a standing goal to improve my profitability from operations?
• The guarantee of profitability in any business will never exist.

Business profits occur at three levels in your business.

Profit is ultimately what’s leftover after employees, suppliers, lenders, and the government has been paid.  The amount remaining represents the business’s return for the capital put at risk to produce this income.  Yet looking at profit only at this level robs you of seeing the three levels of profit that emerge after assigned sources and uses of money are calculated.  Below is the high-level definitions of the three levels of profitability for every business:

Gross Profit	Operating Income	Net Income
Your first measure of profit tells you what it costs you to transform a dollar of sales into a profit.  Without a strong gross profit in your business operations, it is impossible to have a strong Net Income number	Your second most important number from your business operations measures what it cost you to support your operations out of every dollar of gross profit earned.	In any accounting period, Net Income is the end financial result. It is referred to as the Bottom Line of the P&L Statement after all expenses are deducted from net revenues earned.

You need both cash and profit management practices to make money.

No matter the amount of cash flowing through your business, you’ll face internal and external problems outside of your control if you aren’t generating profits.  If your business suffers more losses than profits, you will quickly find yourself in serious financial difficulties.  This is a common occurrence for business owners who fail to understand the differences between cash and profit management:

Cash Management represents the proactive control over cash receipts dispersed through disciplined control over cash outflows based on accurate cash inflow projections.

Profit Management is the organization and coordination of the activities of a business to achieve defined business objectives at a profit.

There are at least thirteen terms related to achieving business profitability you should know.

1. Net Sales represent the total amount of money collected for goods or services sold before any expenses are subtracted during that accounting period. It is the best reflection of how well you are utilizing your capital, capacity, and other resources to generate the top-line of your business, which funds everything else in your business.

Accrued net sales do not represent cash flow, nor do cash sales represent profit.  Net sales only represent what your sales transactions reflect, in total, for that period, as the cash you should collect from completed sales transactions.

2. Cost of Goods Sold or COGS consists of every direct expense related to producing the goods and services bought by your customers. COGS are considered variable expenses because they vary with sales.  If an expense accounted for here doesn’t change as sales levels change, then it’s a fixed, not a variable, expense.  It’s difficult to calculate an accurate gross profit if you have variable costs sitting in SG&A and fixed costs sitting in COGS.  The most common COGS are Direct Labor, Subcontractors, Materials, and Equipment.
3. Gross Profit is calculated by subtracting the direct costs incurred to produce a product, complete a job, or deliver services from Net Sales. Your gross profit percent is the best determiner of how efficiently your operations convert sales into profits.

Gross Profit will never be healthy if it’s a continuous struggle to keep sales higher than the cost of production. If sales are not greater than COGS, there will never be money left over to pay operating expenses or provide the owner with profits.  A high gross profit means stability in times of economic downturn because the company can afford to cut prices; a low gross profit often translates into low creditworthiness and the inability to fight off competition.

4. Gross Margin Ratio represents the percentage of pure profit from the sale of the cost of goods sold to pay operating expenses. A falling gross profit shows that production costs are rising faster than the selling price, or that inventory is shrinking due to fraudulent activity or product spoilage.  Higher ratios are achieved in two ways:

1. 1. 1. Reduce costs by buying materials or labor at a lower price
      2. Sell your products at a higher mark-up

If your percent of Gross Profit earned on every dollar sold isn’t improving noticeably, year-over-year, then your business operations aren’t becoming more efficient.

5. SG&A Expenses are your expenses associated with your selling, general, and administrative costs of doing business. These expenses represent the business’s overhead—fixed expenses that can’t be directly assigned to a job, product, or service bought by a customer.  Because these expenses don’t fluctuate with sales, production, or the market, they should be relatively consistent in amount from month to month and year to year.

If you are accounting for an expense involving an item on which a sale depends and is necessary to complete an order, you have a direct expense.  If you account for that expense here, you will overstate your SG&A expenses and understate your COGS.  The most common SG&A expenses for small businesses include office salaries, rent, professional fees, insurance, and the like.

6. Operating Income or EBITDA earnings are calculated from the company’s Gross Profit, less SG&A, or overhead expenses. This profit number represents the income or profit resulting from your businesses’ primary business operations, excluding interest, taxes, depreciation, amortization, extraordinary expenses, and other income.

The profit view reflected in your EBITDA earnings is used to determine how profitable a company is with regard to operations.  It is a more accurate picture of a company’s success than gross sales, gross profit, or net income.  If you aren’t producing enough gross profit to fund your overhead or have SG&A expenses that are too high, you will not make money.

7. Nonoperating Income is any inflow of monies from earnings or payments received that is not directly attributable to the company’s core business operations. They are accounted for as “nonoperating income or other income” on your P&L statement.

Nonoperating Income usually does not occur on an ongoing basis and is examined separately from Operating Income. Income reported here includes gains or losses from investments, property or asset sales, currency exchange, and other atypical gains or losses not reflected in gross sales.  Such income is often a one-time occurrence; that is why it is categorized as a nonoperating income.

8. Extraordinary or Other Expenses are any cost not directly attributable to the company’s core business operations. Any nonoperating or extraordinary (one-time) expenses considered unusual or infrequent should be reflected here, and not reflected in COGS or SG&A, because they aren’t a part of your ongoing business operations.
9. Interest Expense is simply the money a company pays for borrowing from a bank or other company to buy an asset of any kind. For example, when you buy a piece of equipment using a bank loan, you must pay the amount you borrowed and interest based on a percent of the amount you borrowed.  It is the interest paid, not the principal amount, that is included as a nonoperating expense.  Reporting interest expense within SG&A Expense understates Operating Income.
10. Taxes are levied by a governmental unit for income, consumption, wealth, or another basis. Tax expenses that should be included here involve Federal, State, City, and Property taxes.  Sales tax should be included in your COGS because it is a sales expense that is only incurred if a taxable sale occurs, and as a result, it will vary with sales.
11. Depreciation and Amortization Expense. Depreciation represents the cost of capital assets used over time and is a contra asset account that offsets the fixed asset account.  It is an allowance made for wear and tear on an asset over its estimated useful life.  Amortization is a gradual and periodic reduction of the cost of an intangible asset.  Both depreciation and amortization expenses are non-cash expenses. They do not represent a cash outflow on the income statement since no money is transferred for depreciation. This is because the relevant cash outflow happened at the time the asset was purchased.

When reported on the P&L Statement, this expense will reduce Net Income and should never represent the total amount of depreciation and amortization reflected on your Balance Sheet.  The depreciation and amortization reported on the balance sheet are the accumulated or the cumulative total amount of these amounts that have been reported as expensed on the income statement—from the time the assets were acquired until the date of the balance sheet.

12. Net Income represents your business’s profit after employees, suppliers, lenders, and the government has all been paid—the amount left over goes to the business owner in return for the capital they put at risk to produce this income. Net Income is also called earnings, net earnings, net profit, and the bottom-line.

Net income is the owners’ return from operations, and it should represent an increase in the value of their business investment if the business is profitable.  If the business is operating at a loss, this number represents excess business spending in that accounting period.  Net Income is the only number that transfers from your P&L Statement to your Balance Sheet.

13. Retained Earnings represent the profits that a company has earned to date, less any dividends or other distributions paid to investors. This amount is adjusted whenever an entry to the accounting records impacts a revenue or expense account. It is the most important Balance Sheet number representing the “sum of all profits” retained since its inception. For the purposes of accounting, retained earnings are reduced by losses.  Mathematically, it is the accumulated undistributed earnings of a company retained for future needs, or future distribution to its owners, from profits generated by a company that is not distributed to stockholders (owners) as dividends.

Retained Earnings do not represent surplus cash.  Rather, retained earnings represent the amount of profit that the company has reinvested in the business since its inception.  They are not an asset because they are considered a liability to the business—money that has been set aside to pay stockholders in case of a sale or buy-out of the business.  Consequently, retained earnings are part of the stockholder’s equity.  Retained earnings are also called accumulated earnings, accumulated profit, accumulated income, accumulated surplus, earned surplus, undistributed earnings, or undivided profits.

Understand that the amount of cash flowing through your business does not mean you are a great business manager.  Nor does high cash flow levels mean you are likely to earn a profit, nor do high levels of profit automatically translate into positive cash flow.

The key to being a great business manager is in proactively managing your sources and uses of money at a profit.  You know you are doing this when you aren’t worried about cash outflows exceeding cash inflows.

Why do I always want to have a standing goal for improving my profitability from operations?

Cash is not profits, and profits are not cash.  Those who don’t accept this reality fail to grasp that the best cash flowing into your business is your gross profit cash flow from your direct operations.  You are a successful business when you own a business that is self-funding your business growth from your operating income cash flow.  Setting a goal around how you can do this is always a smart goal that will never grow old.

The amount of your cash flow from operations is a direct function of the quality and velocity of the cash coming into your business.  The quality of cash is a function of your Gross Profit and Operating Income.  Cash quality represents the amount you have left in the bank from your net sales after your COGS, SG&A, and other nonoperating expenses are paid.  In the long term, your business needs to be about continuously improving your cash quality.  Below is how this back and forth between cash, profits, assets, and liabilities looks from both a P&L Statement and Balance Sheet view:

The guarantee of profitability in any business will never exist.

Since profits are always a lagging measure, it doesn’t matter what profit margins your business produced in the past or whether you had a profit plan.  What does matter is the hard reality that every business must face: There is no guarantee that your business will be profitable this year.

Ensuring that you will have a profitable business in the year ahead starts with building a profit plan.  And most notably that you use this plan to manage your business throughout the coming year.  Without a profit plan, you will never know if you are tracking above or below your profit goals through the year.   On a personal level, you will not have an accurate sense of whether your business can provide enough profit to be worth your time and investment risk if you don’t have a plan.

Where is your money going?

Click here to learn how your business profit and cash position have changed over the last three years, looking at your year-over-year change by month in cash position and profits.  Doing this will help you better see patterns and trends in your business that you can take action to fix.  Ultimately, any failure to fix profit leaking from your business is a failure to manage your cash.

Within forty-eight hours of receipt of your core financial statements by month, you will receive back by email your free financial statement review from a certified BusinessCPR™ Business Scientist.