Some entrepreneurs assume that determining whether a business makes money is pretty straightforward. If you have money in the bank and your enterprise stays operational, doesn’t that mean the business is profitable? Well, not exactly.
As a business advisory consultant, we know that calculating business profits is more complicated than that. The truth is, relying on your bank statement instead of your business income statement won’t give you the full financial picture. We’ve come across many businesses, mainly in the service, tech, and engineering sectors, struggling to work out the profits from a single client, job, or venture.
From our professional perspective, here are five key steps for calculating business profitability:
1. Tally Your Operating Expenses
You have to know all the business’s operational expenses in order to calculate your profit. Depending on the business model, expenses may include labor, rent, taxes, equipment, service fees, insurance, and energy costs. Remember, when calculating profits on a per-job basis, you’ll only consider the operational overheads of the job in question. Fixed expenses only come into play when analyzing long-term or periodic profits.
2. Calculate Gross and Net Turnover
Gross revenue is the total sum you get from a service or product sale. If the job is paid in one lump sum, then it’s a simple matter of picking the total payable amount. Some clients like to pay in multiple phases, especially for huge sales. In such a case, you'll have to sum up the gross turnover from multiple receipts, invoices, or bank statements.
Once you have the gross income, you can calculate the net profit by subtracting the total expenses from the gross revenue. A positive number means you made a profit, and a negative represents a loss.
Gross revenue – Total expenses = Net profit
3. Determine the Profit Margin
The profit margin is a measure of how much money you made relative to the gross income. Profit margin is expressed as a percentage of the net profit to gross revenue ratio. It shows you the fraction of profit generated from each unit of revenue. For instance, a 25 percent margin tells you that every dollar in revenue generated a quarter in profit.
Net profit / Gross revenue X 100 = Net profit margin %
4. Compare the Rate of Return
The profit margin helps you determine which jobs or sales are more profitable than others and gives you a measure of business performance. It’s also important to gauge your profitability against the industry’s standards to determine whether your business is below or above the profit threshold.
Talk to a business advisory consultant in your industry to find out what your competitors charge for similar services or goods and calculate how much they make on average. If your profit margin is below average, it might be because your price point is too low or the overheads are too high, meaning you’ve lost some money on the job – though not directly.
5. Follow the Money
Finally, another way to analyze profitability is to follow a job’s or sale’s cash flow and understand the value that the profit or revenue brings to the business. It’s crucial to look at profitability from a long-term perspective. Besides covering overheads, the revenue generated after each sale should also go toward business growth. Ask yourself whether the profit you make is enough to help the business sustain itself, boost sales, and expand your enterprise operations.
Not every single sale should generate enough cash to make a noticeable impact. Still, the profit margin and ROI should indicate that the income contributes toward the bigger picture.
A comprehensive and accurate profit statement gives you an overview of the business's performance. However, calculating profits can be a laborious process involving a lot of paperwork and tedious number crunching.
If you're having trouble managing your business's cash flow and drafting or analyzing your profit and loss statement, our business advisory consulting services can help. Based in Broomfield, Colorado, KRD Tax & Accounting specializes in helping businesses grow by offering professional advisory and accounting services. Contact us today and learn how you can streamline your financial operations.