Is Profit something that happens to you and your business or is it something over which you can take direct control?
I think that most entrepreneurs think about Profit the wrong way. When you read a profit and loss statement, profit comes last after tax and seems in some way to be the result of all the activity above it. Profit therefore is something that happens to you and your business. It is the effect of all that activity and effort.
In these two posts, I want to show you the Six Simple Strategic Steps to finding the Profit Formula.
What Profit are we talking about?
Firstly let us all agree what do we mean by profit.
There is EBITDA, EBITA, EBIT, PBT and PAT! Confusing isn’t it.
Most Private Equity and Venture Capital firms focus on EBITDA – Earnings before Interest, Tax, Depreciation and Amortisation. This a proxy for the free cash flow that a business earns, independently of how the balance sheet is financed.
However, as an Entrepreneur, you are only interested in Profit after Tax. Why? Because until the business has paid all its dues, the remaining cash cannot be distributed to shareholders, i.e YOU.
This suggests that Profit is an effect of all the activity and not the main purpose of it. In reading the P&L account this way, it is easy to get the impression that profit is something that happens in a business and not something you have direct control of.
This is the wrong way to think about Profit.
Turn Profit on its Head
Turn the Profit and Loss Account upside down and start with Profit.
Ask yourself, what Profit do I want to make?
Let us be realistic here. Few businesses can sustainably make more than 20% Profit but you had better make sure that you are sustainably able to make 5% after tax. So that is the basic range. Most businesses should be capable of making between 10% and 15% after tax.
So that is the objective.
Firstly you need to gross up this % for the normal rate of corporation tax(es) you will be charged on your profit. These vary by size of company and jurisdiction but lets use 30% as a working proxy.
So now your objective is to make between 20% and 15% PBT or profit before tax.
For this purpose we can now ignore Depreciation and Amortisation which are non cash items which relate to items on your balance sheet and are the result of historic investments. They do need due consideration at the appropriate time, but this is not it.
However, where business costs, such as Lease Payments, are treated as a Balance Sheet Adjustment and covered by Amortisation, you should build these into your Profit calculations as they are real cash costs of your business and belong in the Financing costs section.
Having assured yourself that the Taxman is properly taken care of, you can now turn your attention to a very small group of variables.
Six Key Variables
- Financing Costs
- Variable Costs
- Fixed Costs
- Labour Costs
- Cost of Sales
- Sales and Prices
This essentially relates to Bank and other interest and is the money you have to pay to cover the debt related elements of your company’s finance. If you are entirely funded by equity, this will be low. If you are highly geared, this element will be much higher. Private Equity like high gearing because it reduces the amount of equity they have to put into a business and at the same time they can offset this against tax and therefore reduce their bill from the Taxman. A double whammy!
As an Entrepreneur, if you are highly geared and your business performs badly in one year, your business could be at risk so I do not generally advise on aggressive levels of debt in a business.
Don’t forget to include all Lease Finance costs into these calculations – we are ignoring amortisation – but these are a part of your business’s financing structure and has a real cash cost.
You need to look at this cost as a % of Revenues.
These are the Operational Costs in your business that are not fixed by contract and over which there is some discretionary choice. These include marketing, motoring expenses, stationary, phone costs etc.
At this point it is too early to dive into the detail of them but again I want you to think about them as a single group and a % of revenues.
These include rent and rates and other cost items which you have contracted to pay. They will include lease finance costs for office items such as furniture or photocopiers.
Note I have separated salaries into a separate class.
What % to these make up of your revenues?
These items include all the costs related to your employees and yourself. Salaries, Bonuses, Social Security expenses, additional benefits. I would include all your employee cost here. Do not leave any in your cost of sales. This distorts both figures and reduces your ability to control both variables.
In this calculation it is important that you are fully costed into the equation. Many Entrepreneurs pay themselves less than the going rate while they are building their businesses. This is fine but when setting out to create a business which produces a satisfactory level of profit you cannot do this.
So what % of Revenues is this element of your costs?
Cost of Sales
Now we are getting down to the nitty gritty, as they say. Your Cost of Sales encompass all the remaining costs of producing your product or service. You have already covered all the staff costs, all the fixed and variable costs so this should be costs purely related to the production of your product or service.
What % is this of Revenues?
This last element, which is normally at the top, is now the critical driver which you can analyse to review the current status of your business.
This is determined by taking the total cost of sales from the total revenues. While businesses will of course have a range of products, services and pricing structures, I want you to be able to think of this in terms of £1 of sales is equal to say £0.50p of gross margin, implying you have a 50% cost of sale and therefore a 50% gross margin.
Having done the analysis above, we can now look at the variables as drivers of Profit over which we can begin to exercise control.
- Labour Costs
- Fixed Costs
- Variable Costs
- Financing Costs
- Tax Costs
Apply the % of sales figure to each of these to derive your % Post Tax Profit. Is the result between 10% and 15%. Probably not I would suspect.
In Part 2 of this blog post I will show you how to work with these variables to start to strategically construct your Profit and Loss Account so that your business’s Profit is something that you make happen rather than something that happens to you.