Profitability analysis: it may come as a surprise to many people that some of the fundamental knowledge you should have as a business owner revolves around knowing whether your business is profitable or not.
And yet, time and time again, I head into client meetings, and the first thing I ask them is whether they are profitable and if so, how much are they making?
Here’s the scary bit though – these business owners often check their bank account balances as if this is the way to find out if they’re profitable.
WRONG.
Contents
The Importance of Knowing Your Numbers for Profitability Analysis
And by numbers, I don’t mean your bank account balance.
Every business generally incurs an expense to operate your business. These can come in the form of fixed or variables costs that should be recorded somewhere, preferably in cloud-based accounting software (more on that later).
Revenue is simply the income generated as a result of a sale of your product or service.
Depending on the complexity of your business, profitability analysis is as simple as calculating your revenue minus your expenses (or costs).
Here’s where it gets a little more confusing and why checking your bank balance doesn’t work:
Not all expenses or profits are paid at the time they are incurred or sold.
This may be because you have payment terms with suppliers that mean you get paid within 30 days, or your overheads are charged on a monthly or quarterly basis, or you’ve yet to pay your upcoming tax bill.
All of this should be accounted for when calculating your profit or loss and forms a fundamental part of your profit and loss statement – a financial statement that is imperative in knowing whether your business is profitable or not.
By checking your bank account balance, you’re failing to account for these and much more which proves to be an extremely inaccurate representation of whether your business is profitable.
Also, an inability to identify how much cash is coming in and out of business on a month-to-month basis can eventually result in business failure. It’s the equivalent of driving blind.
The consequences can be severe if you are unknowingly operating an unprofitable or unsatisfactory cash flow business.
You might also be interested in our article on 6 Reasons Why You Need Financial Statements
Profitability Analysis for Financial Stakeholders
If you think merely doing a profitability analysis is only for the ATO, think again.
Times are changing, and small business owners will be running into financial stakeholders such as banks, lenders, insurance companies, investors, property managers and landlords. These stakeholders will expect small business owners to know their numbers as they tighten their stance and policies.
As a result, it is now commonplace for these stakeholders to request financial reports from small businesses to ensure that they are also safeguarded against businesses that are not profitable and therefore, higher risk.
How Cloud Accounting Software Helps with Profitability Analysis
Gone are the days of waiting for your accountant to produce annual financial statements to find out where your business’ financial position is at.
Instead, you now should have access to this at your fingertips by using software such as Xero, Quickbooks or MYOB.
All of your revenue and expenses should be recorded here (bookkeeping), and this should provide you with an instant snapshot of the direction your business is heading at any one time.
By using cloud base accounting software you don’t just know your profits, but also the current liabilities you need to pay in the next month or two (i.e. income tax, superannuation, GST, accounts payable, suppliers, etc).
Critical Decisions & Key Metrics for Profitability Analysis
Once you have analysed your profitability and know precisely where your business stands in terms of its costs, revenue and liabilities – this is where you utilise these numbers to keep things under control.
If your expenses appear to be too high, then this is an excellent opportunity to review things and make adjustments to bring down your costs. Conversely, you may be under-charging for your product or services and may require a revision of the pricing model of your product.
If your liabilities are high, then it could be an excellent time to start looking for extra funds for your business to keep the cash flow running in the business.
You may find that developing a new set of crucial profitability metrics based on your numbers can help you with knowing your break-even point for your business product. For example, understanding the cost of customer acquisition or perhaps the baseline price to ensure profitability for each unit of product sold, will ensure that you do not unknowingly drop your prices too low.
Depending on the type of product or service you sell, many companies even develop profitability ratios such as gross profit margin, break-even analysis or even profit by segment if your product comes from multiple sources.
Key Takeaways
Despite the simplicity behind figuring business profitability analysis, there is a layer of complexity that must be accounted for to ensure that you are getting an accurate representation of whether your business is profitable. By ensuring precise bookkeeping, this provides a strong foundation for business owners to improve the management of their costs and pricing.
Ideally, many business owners can set this up themselves, but often, a qualified accountant can provide much-needed support and insight into where things can be improved.
Box Advisory Services’ team of Chartered Accountants are well versed in helping analyse the profitability of your business and ultimately provide guidance on improving its financial position. To find out more, book a FREE 45-minute initial consultation to find out how we can help you.
Sign up to our monthly newsletter where we share exclusive small business and contractor advice!
Disclaimer:
Please note that every effort has been made to ensure that the information provided in this guide is accurate. You should note, however, that the information is intended as a guide only, providing an overview of general information available to contractors and small businesses. This guide is not intended to be an exhaustive source of information and should not be seen to constitute legal or tax advice. You should, where necessary, seek your own advice for any legal or tax issues raised in your business affairs.
