Profit: How to get your share when starting a business
When it comes to profit, it can often seem like “the grass is greener” and everyone else is getting much more than you. But profit is much more than cheap thrills – it’s the pulse of your business venture.
Check the annual results for the S&P 500 or ASX 100 public companies and you’ll find their 30-year average net profit before tax hovers around 12 per cent (in 2017 S&P 500 was 10.6 per cent).
Ask 20 successful small to medium enterprises (SMEs) operating successfully under fair conditions, and you’ll probably find that they are making from 8 to 25 per cent in net profit, with most of them towards the bottom of that range.
You must have a healthy profit to have a healthy business, and while business is so much more than merely making a profit you can’t have a good business without profit.
Keeping a constant eye on the health of your business via your profits guards against the self-delusion of thinking that ‘“doing lots” is enough. Use your profit to check whether you’re “doing lots – of the right things”.
You can fool yourself – even about profits – but you can’t fool your piggy bank. It’ll tell you the truth every time.
What is net profit?
Conceptually, net profit is what’s left after paying all the costs of selling something and running the business. Mathematically, net profit % = (sales revenue – cost of sales) x 100.
Pragmatically, however, none of those captures the truth quite as succinctly as, “Sales are vanity. Profits are sanity. But cash is king!”
To test the truth of that saying, ask anyone in business whose booming sales have run them hard up against their overdraft limit as they’ve scrabbled to find more and more cash now, to buy more and more stock soon, to sell more and more stock – later!
It’s called ‘overtrading’ and it’s one way you can be selling profitably – and still go broke.
How does this happen?
Often the business owner started with a low-cost, low-profit model that attracted lots of attention fast and built early sales, but those sales did not carry sufficient profit with them to begin to create a pool of cash that might then be used to fund future growth.
The cost of capital
To start and run an enterprise you’ll need capital. To grow it you’ll need more capital. Capital from investors (owners included) has a price, either at a fixed rate as “interest” or at a variable rate paid as “dividends”, a percentage of the profits generated by its use.
In a balanced market, risk and reward vary in direct proportion: the higher the risk the higher the expected reward, dividend or interest.
Investors punting their capital on a new biotech company and respecting the high risk of failure may be drawn to the prospect of very high rewards if successful. Conversely, putting money in the bank has little risk and so earns only very low interest.
In a small to medium enterprise the risk of going bust is many times higher than for a major bank and quite a few times higher than most of the listed public companies paying their investors 10 per cent or more in annual dividends. Those same companies may also be providing their shareholders with capital growth in the value of their shares. All for just putting their money in and waiting!
So if a public company returns its investors 10 per cent or more a year, what should an at-risk small to medium enterprise be returning its shareholders (its owners), especially when they are probably working long hours in the business?
Clearly, several times that, but let’s work on 20 per cent for now.
Separating workers and shareholders, wages and dividends
Identifying what’s yours for working in the business (a salary package you’d offer to attract someone capable of and willing to fill your role – say $100,000 p.a.), along with what’s yours for putting your capital at risk (a dividend you’d have to offer an investor to put their capital at risk in your business – say 20 per cent), and separating those from the enterprise’s normal working capital, is essential.
If an owner invests $500,000 in a franchise license or in start-up stock then the first $100,000 of profit is owed as a dividend or interest to the investor/owner for use of their capital.
Trying to run a business by steering via your bank account (“by the seat of your pants”) can mislead you into seeing free cash in the bank as “profit” when in fact it’s actually your unclaimed wages and your unclaimed dividends both hiding the fact that you are making little or no real profit. In fact, you could well be making a loss.
That’s where some clear thinking – and a little basic bookkeeping – comes into the picture.
If you draw just $500 a week from your enterprise as the bare minimum you need to live on, then your enterprise is accumulating $1500 a week of debt to you, its best worker, and $2000 a week to you, its investor.
Mentally deducting $3500 a week, every week, from your cash holdings ($14,000 a month; $168,000 a year) will give you a truer reading of your pulse and a reality check on the way you are doing business.
Why the grass always looks greener
If there’s not more than that ever-accumulating figure in cash (or saleable new assets or stock) accumulating in the business, then you are trading at an actual loss.
So how come you’re still afloat?
That’s easy to answer: you’re personally subsidising your business every day with labour and capital to keep it that way. But if the purpose of your business was to deliver you a reward for labour, risk and entrepreneurial initiative, then are you achieving that? Probably not!
So, it’s time to look for cost savings and time to seek out more ideal, higher-paying customers; and only once those two are in place, then it’s time to sell more.
In summary, take one simple step to get yourself on track: pay yourself first and pay yourself a realistic salary and a fair return on capital, in cash. Taking this action will scare you into a never-ending commitment to reduce your costs, increase the value of your business, and protect your cash.
And if your enterprise hits a tough patch, you’ll know someone who has the cash to make a short term loan – at reasonable rates, of course – until you’re through it.
Peter Rowe is head coach and CEO of ProfiTune. His sole purpose is applying the world’s most effective systems to move his business clients to success.