Chapter 4 of the Business finance basics section in the 'Achieving financial success' series

Chapter 4 of the Business finance basics section in the 'Achieving financial success' series
Chapter 4: Maintaining profitability

By David Jenkins*

Now you have been introduced to the basics of business finance, you can use these tools to improve the financial management of your business.

Proactive management of the financial position of your business will ensure any issues encountered will be identified early so that appropriate action to rectify the situation can be taken in a timely manner.

Through the use of the financial information discussed in the previous chapters, and by implementing the processes introduced in this section, you will be well on the way to achieving good financial management for your business.

Profitability and cash flow are the key areas that should be monitored on an ongoing basis to help ensure your business prospers.

This section of the guide presents a number of easy-to-understand procedures and tools that can assist in maintaining profitability and improving cash flow.

Managing business finances is all about taking a practical approach to maintain profitability and improve cash flow, together with having the discipline to continually monitor and update the financial information as circumstances change.

Maintaining profitability

One of the most important challenges for any business is maintaining profitability. A profitable business will ensure you can manage your business in line with your overall strategic objective, whether it is to grow the business or to sell at a later date or some other objective.

In this chapter, we look at three useful tools that will help you monitor the profitability of your business.

We also discuss how discounting can affect your profit, and of course we look at managing the expenses of the business to maintain profitability.

Profitability measures

Once you have a profit and loss statement, you can use the tools explained below to ensure you know:

• that your profits are not being eroded by increasing prices in stock or expenses - margin

• how to set new selling prices when stock costs increase - mark-up

• how much you need to sell before the business is making a profit - break-even analysis.

Margin

There are two margins that need to be considered when monitoring your profitability: gross and net.

For a service business, only net margin is relevant, as it is unlikely there would be a direct cost of service provided.

Gross margin is the sales dollars left after subtracting the cost of goods sold from net sales.

Net sales means all the sales dollars less any discounts to the customer and commissions to sales representatives.

By knowing what your gross margin is, you can be sure that the price set for your goods will be higher than the cost incurred to buy or manufacture the goods (gross margin is not commonly used for service businesses, as they most often do not have 'cost of goods'), and that you have enough money left over to pay expenses and, hopefully, make a profit.

Improving business finances means you need to take a practical approach to implement new processes that allow you to monitor the key aspects of your business: profitability and cash flow.

It is very easy for profitability to be eroded if you do not measure and monitor on a regular basis.

Therefore, it is important to understand how to use the tools available to continually evaluate the profitability of your business.

Gross margin can be expressed either as a dollar value (gross profit) or as a percentage value that measures the percentage of sales dollars remaining (after obtaining or manufacturing the goods sold) to pay the overhead expenses of the company. (The percentage value is particularly useful if you are comparing your business with other businesses in your industry or with past performance of your business.)

Net margin is the sales dollars left after subtracting both the cost of goods sold and the overhead expenses.

The net margin will tell you what profit will be made before you pay any tax.

Tax is not included because tax rates and tax liabilities vary from business to business for a wide variety of reasons, which means that making comparisons after taxes may not provide useful information.

The margin can be expressed either in dollar value (net profit) or in percentage value. (The percentage value is particularly useful if you are comparing your business with other businesses in your industry or with past performance of your business.)

Mark-up

Mark-up is the amount you sell your goods above what it cost to purchase or manufacture those goods.

It is generally a meaningful figure only when referring to the sale of products rather than services.

It can be useful to use the mark-up calculation to ensure you set the selling price at a level that covers all costs incurred.

Mark-up is calculated as follows:

Break-even calculation

The break-even calculation shows how many sales have to be made, in either dollars or units, before all the expenses are covered and actual profit begins.

This simple calculation is used to find where profit really starts. The break-even point is calculated as follows:

We can use Joe’s profit and loss statement for year 1 (from Chapter 1) to calculate the profitability measures for his business.

TIP
Compare your profitability measures with those of businesses within the same industry to ensure you are competitive and achieving maximum profit potential.

Discounting sales

Discounting your goods or services to entice customers to purchase may erode your profits.

Of course, some discounting can be beneficial; however, before you decide to offer discounts, it is important to understand the impact discounting will have on your profits.

Alternatives such as add-on products or services may deliver more dollars of gross profit to the business and should be considered before deciding to offer discounts.

In the previous section, we discussed sales 'net' of discounts. When you discount, you are effectively offering your goods or services at a reduced selling price, and you will need to sell more goods in order to achieve your gross margin.

Let’s return to Joe’s Motorbike Tyres. He is considering offering a 5 per cent discount to encourage more sales. If gross profit is currently at 40 per cent Joe needs to increase his sales volume by 14.3 per cent if he is to achieve the same profit with the desired discount.

HINT
Consider offering your customers add-on services as an alternative to offering discounts.

If we put some numbers to this, we can see the results in the box below.

In a service business, if the selling price is cut by 5 per cent and the net margin is 30 per cent, sales will need to increase by 20 per cent to ensure all operating costs are covered.

TIP
Always calculate the impact on profitability before offering discounts.

Expense management

Good management of general expenses by the business will contribute to increasing profits.

By monitoring business expenses, you may be able to identify where costs are increasing and take action to ensure you maintain your net profit margin.

HINT
Keeping a close eye on your expenses will ensure you maintain the profitability of the business.

When monitoring expenses, don’t forget to identify the expenditure that keeps you in business (for example, presentation of premises, marketing, staff training) and keep these at sustainable levels.

To maintain constant rigour on expenses, continual review will help identify where costs are getting out of hand. Don’t forget to use the profitability measures, as they are the simplest and quickest way to see if your profits are being eroded.

Here are some other ideas to help you manage expenses:

• Consider joining forces with other businesses to benefit from group buying discounts.

• Investigate companies that provide access to discount services for bulk orders.

• Seek quotes for different services to ensure you are paying the best possible price for your expenses.

Often, if you are a member of an industry association, the association may have established relationships with service providers such as insurance companies and you may be able to access discounted services or products through your membership.

However, be careful not to focus too much on individual expenses. The dollars you could save from such an exercise might be outweighed by the cost of your time and the aggravation such a focus may cause your staff, suppliers or customers.

TIP
Look for opportunities to join with other businesses for group buying that could provide discounts on your expenses.

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The full Guide is available in the .pdf attachment, or here »

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David Jenkins is the New Zealand-based manager of the global professional accounting body, CPA Australia. You can contact him directly here »

You can read the Introduction to this series here »  The related Glossary is an important resource. And readers are encouraged to read this page first »

Chapter 1 is about Understanding financial statements and you can read it here »

Chapter 2 is about Assessing your busines's financial health and you can read it here »

Chapter 3 is about the Importance of Budgeting and you can read it here »

Chapter 5 is about Improving Cashflow and will follow next week.

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