Analyzing Profit Margins FAQs Part 2: Profitability

A company’s margin of profit is one of the most important indicators about its health.

In this second post, I share answers from my live video event including:

  • Which numbers should I be looking at?
  • What’s the difference between a Measure, Metric, and KPI?
  • Are “sales” and “profit” the same thing?
  • How do I expand without running out of cash?

This article also jumps into the topics of Transaction AvoidanceLottery Mentality, and self-sabotage as a business owner.

Watch part 2 of the recorded video here, or read the transcript below (including bonus content!)

https://www.youtube.com/watch?v=vx07Bs4NKtU&t=17m30s

I decided to take my Facebook Live in a different direction this time. In previous topics (like Vision & Mission and Company Culture), I focused on questions I’ve been asked in my consulting work.

The first part of this postfocused on my philosophy about money and why I think it’s so important to understand your blind spots and biases.

Now, we will dive into some Frequently Asked Questions about profit and finances in a business.

Frequently Asked Questions about Analyzing Profit Margins

1. Which numbers should I be looking at to make sure my company is growing?

My answer is not necessarily a set of numbers.

The financial viability of any company depends on the decisions of its leaders, which are based on the leader’s core beliefs.

So to answer this question, I wouldn’t necessarily direct you to look at numbers—like your outstanding A/R (Accounts Receivable), your profit margin, your overhead costs, or your percentage of scheduled visits.

These are all secondary.

Instead, your focus should be on the answers to these questions:

1. Where does your money come from?

Which services or products are causing you to generate revenue? Which customers are paying you?

Profit is the difference between total sales and expenses.

It’s a pretty simple equation, but this can get complicated.

If you’re a finance aficionado and you enjoy doing this kind of thing… then you know all about an Income Statement, which takes Gross Sales and subtract the Cost of Goods Sold (COGS), then subtracts Operating Costs, Depreciation & Amortization, Interest, and Taxes. When you take away all the expenses of running your business, you are left with a Net Profit.

This figure is really important in calculating the health of your company—but there are many other indicators of overall health.

I encourage you to consider both the quantitative aspects of your business (calculating where your sales come from, and how much profit you generate), as well as qualitative aspects (which customer relationships are strongest, which services are most fulfilling, and how much of a difference you are making both financially and otherwise). Read more about this topic in How to Estimate the Qualitative Loss From Staff Turnover.

Considering the quality in your business transactions can new open doors of opportunity.

Think about the quality of your sources of payment.

  • How easy is it to conduct transactions?
  • Which customers are eager to pay rather than difficult to deal with?
  • Do you have systems to generate passive income, or are you relying on a single source of revenue?

Looking at “just the numbers” gives you a limited scope about how your company is really doing.

There is more to your financial situation than what is stated in a report. By asking questions that go beyond your Balance Sheet and Profit & Loss statement, you will be able to consider your ultimate goals for the company.

2. What are you spending?

On a Profit & Loss Statement (also known as an Income Statement), what are the expenses? Where is money going when it leaves the company?

Have you made investments that haven’t turned out as profitable as you’d hoped?

Do you have higher expenses than you should? Sometimes, we make financial commitments based on overly optimistic expectations.

Are you getting further into debt every month? Do your bills keep rising?

Instead of waiting for the inevitable day when you have no money left, it would be better to plan ahead. Ask: “Am I spending more money than I should at this point? What can I cut out of the budget?”

One mistake is to make decisions with a sense of overconfidence. You may have such strong beliefs about how beneficial your services or products are, that you expect to have no problems getting sales. This can lead to “borrowing from the future,” by taking loans, making capital purchases, and buying things in anticipation of a future payoff; but that payoff may never happen. What is your level of overconfidence?

3. Where are you going?

  • What are your goals for the business?
  • Which financial level do you want to achieve?
  • Do you want to eventually sell the company and make a profit?

Your goals can be in a variety of areas:

  • Security
  • Sense of purpose
  • Stronger relationships
  • Amount of monthly income
  • A nest egg of $5 million
  • Luxurious lifestyle
  • Ability to generously give to others

When you are clear about your personal and professional goals, this can have a profound effect on which decisions you make as a business owner.

It’s so important to plan for the eventual future of your business now.

The decisions we make now will affect what happens in 5 or 10 years. The decisions we already made 5 or 10 years ago result in the situations we’re experiencing right now. As the saying goes, we “reap what we sow.”

Consider what you’d like your business, and your life, to be like. Try to visualize what that future point feels like, and decide what needs to occur for that reality to take place. You can use the Scrooge Effect process, which I’ve outlined here.

A Christmas Carol, Scrooge, Alastair Sim, 1951
“A Christmas Carol” movie cover with Scrooge

Asking questions about your future will also help you consider the financial decisions needed to achieve those goals.

4. Are you on track to get there?

Rather than reviewing specific numbers in discussions about profitability, I like to start by asking about your financial philosophy including sources of goals, beliefs, and assumptions.

This final question provides clues about the application of that philosophy. If we look at the degree of financial health in your business right now, and the goals you have for the future, we can determine whether you’ll be able to meet those goals.

Are you saving enough (generating high profit) to allow you to reach those goals?

Or are you “breaking even,” with no realistic chance of saving money?

Without a regular inflow of profit, you won’t be able to expand your business, increase your personal income, give staff a bonus, or invest in new equipment, etc.

1b. What’s the difference between a Measure, Metric, and KPI?

We’re talking about how to measure numbers, which involves deciding whether you’re on track to achieving a financial goal, like profit margins.

I want to explain the differences between some of these terms.

business data, evaluation, data evaluation, measures, metrics, KPIs, key performance indicators, critical success factors, goals and objectives, strategic risk

Measures

Profit is a measure. It’s a point on a graph that shows how much you’ve earned. It’s a raw number or reading.

It’s similar to the reading that your meter checker takes when they come to your house. They review the rate at which you are using electricity, and you get a bill in the mail that reflects the amount of services you’ve used. This is an example of a single point on a graph, and it’s called a measure.

Metrics

When we comparing a measure with something else, it’s called a metric. We can analyze relationships to understand movement (growth or decline), quality (increase or decrease), engagement (higher or lower), and other effects shown by the numbers.

Metrics can be a percentage, ratio, average, or rate.

One type of metric is Profit Margin: a percentage that shows how profitable your business is. You can calculate this by taking your Total Sales, minus the Total Expenses, divided by the Total Sales.

This is a percentage that can tell you whether you’re making money overall, or not. A low percentage shows that you’re spending a significant amount of what you earn; and a higher percentage means you’re spending less and have money left over.

So a measure is a point on a graph; and a metric is a percentage or ratio used to analyze relationships between things.

KPIs

The most important metrics become what we call a KPI, which stands for Key Performance Indicator.

If I’ve lost you already, I’ll try to make it very simple. A KPI is the most important numbers that show whether you’re reaching your goals or not. Some business owners like to use a dashboard, which is a visual representation of how well the business is doing. It includes things like:

  • how many customers or patients they see in a day,
  • how often they see them,
  • how many visitors and clicks on your website (although it would be more important to note the conversions, or people who buy something from you),
  • the percentage of net profit you’re making from each sale,
  • what types of services are the most profitable.

There are so many KPIs you could use; it all depends on your industry, your priorities, and your niche—the specific problems your company solves (which I’ll get into in an upcoming event).

KPIs are most important ratios and “move-the-needle” indicators in your business. You can do this by isolating the 3 to 5 most important numbers that show whether or not you’re moving toward your goals. You should be reviewing these metrics every day to see whether they’re increasing (sales, profit margins, satisfaction rate) or decreasing (customer complaints, product returns, turnover).

The main purpose of KPIs is to keep you on track to reach your ultimate goals.

Critical Success Factors

KPIs lead into another popular strategic business term called Critical Success Factors. These are decisions that are vital to make the strategy work.

Goals and Objectives

Finally, the top-most targets for your business are called Goals (where you’re headed), and Objectives (how you’ll do it).

I like to review 5 main areas for goal-setting, including:

  • Vision (What the future should look like because of your business),
  • Mission (Who you serve and Why),
  • Vision (Which beliefs guide acceptable behaviors)
  • Objectives (as mentioned above—How you’ll achieve the Vision), and
  • Measures (What guideposts show you’re on track to getting there).

You can find out more about the strategic growth sphere in part 1 of this series.

We’ve briefly discussed some KPIs (Key Performance Indicators) and benchmarks—KPIs you’re trying to reach. There are many software programs that can represent your progress toward goals with a color-coded visual dashboard, where:

  • red = under-performing;
  • yellow = not quite there;
  • green = doing as expected or better.

You can use a software system to keep track of these and see the results each month, or you can track the numbers on your own by hand or with an Excel spreadsheet.

Some of my clients prefer not to use computer systems, so I understand the hesitation of using a complicated software system. In that case, you can rely on an Excel spreadsheet or outsource your analysis to an accounting or financial expert.

The more time and effort your spend reviewing your numbers and why they change, the better you’ll be able to make risk intelligent decisions.

2. Can you explain the difference between “sales” and “profit”? Or are they the same thing?

Sales is the money you collect from customers.

Profit is what’s left over after you subtract expenses.

I think a lot of business owners, especially if you’re not numbers oriented, tend to get these terms confused.

You may have a great month of “sales” (which is interchangeable with “revenue,” although it can include investments). But if your expenses have also increased, you may not have much left over.

So your profit margin (the percentage of what is left over) may be very low.

It’s important to face these questions directly.

Don’t be afraid to talk about the difficult things your numbers may be telling you.

Keep in mind that difficult topics, especially if they relate to past experiences where money has been tight or you didn’t have enough, can be hard to face now that you’re in charge.

Maybe you are holding back or self-sabotaging.

You could be making decisions in order to protect others, or to self-preserve; but it’s actually causing your business to have difficulties.

The more you can dive into the reasons for your decisions, the faster you’ll be able to develop Risk Intelligence—which means that you can understand the potential threats and do something about it.

3. What can I do to expand my business without running out of cash?

I would focus on the 80/20, which is an economic principle where 80% of results come from 20% of actions.

For example:

  • 80% of your income is coming from 20% of your services
  • 80% of your time is spent on 20% of tasks
  • 80% of problems comes from 20% of customers

While the exact ratio doesn’t hold true for everything [it may be 90/10 or even 90/20 or 80/10], it is a fascinating principle that can transform the way you look at your business decisions.

Most of your money is coming from a small number of sources: services or products, customers, or a single department.

If you’re short on cash, I would explore that area and look for ways to expand it.

4. This year was profitable, but how can I prepare for a not-so-good year?

This is another topic that can be uncomfortable.

I strongly recommend lowering your debt ratio, and choosing to not get in debt if possible. This is not always practicable, but debt will have a profound effect on your ability to achieve goals.

Your company may change rapidly due to the economy, interest payments can spiral out of control. Debt can eat away at your ability to control your business, as well as your confidence level as the owner. It would be better to avoid this if possible, and focus on increasing the profit rather than hoping “things will get better” (which I call the Lottery Mentality).

5. Can you recommend a good book about Analyzing Profit Margins?

To learn more about this topic, I recommend that you refer to “The Essentials of Finance and Accounting for Non-Financial Managers” by Edward Fields. I bought the 2nd edition, but the 3rd edition looks fantastic as well.

finance essentials, finance and accounting, Edward Fields, non-financial managers, finance book

I bought this book when I was a data analyst and needed to understand how to evaluate numbers, Profit & Loss Statements, and other financial reports.

This book offers a really good review of finances for someone who’s not very comfortable with numbers. It provides some realistic examples of a company’s potential challenges and helps you know what to look for on your Profit and Loss Statement.


I hope you’ve enjoyed this discussion. Check out part 1 of this series here.

If you have other questions about profit and business decision-making, send me a message and I’ll be happy to answer your question.

Join me at an upcoming virtual event.

If you feel frustrated with your company’s profit margins and want to discuss some ways to make changes, schedule a free 30-minute consult with me today.

Grace LaConte is a Strategic Risk Expert who helps service business owners find and fix organizational vulnerabilities. Using her experience as a Risk Officer in the healthcare and technology fields, Grace shares a refreshingly honest approach to uncovering hidden risks and opportunities. Learn more at http://laconteconsulting.com, or connect with her on Twitter @lacontestrategy.

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