How to profit from profitability

Sounds odd, doesn’t it? But it’s amazing that business owners sometimes do not know what profit is. And how crucial is that in attaining your Business Plan objectives? Much has been written on the subject, but they tend to plunge into technical accounting terms all too quickly. We hope to clarify more within this blog.

A few simple thoughts for starters who wish to understand more about what profit actually is.

Being profitable is not the same as making a profit

Your business may be capable of generating profits on paper (and this is where the accountancy stuff can confuse), but making true profits (i.e. exploiting the Company’s profitability) is down to good management, pure and simple.

Cash is not the same as profit

Some folks feel that they are making a profit just by looking at the bank balance. If it shows a healthy surplus, they may assume that they are coining it. This ignores the fact that payments arrive at different times unrelated to related expenditure invoices.

Invoiced sales may show up as being profitable in the monthly Profit & Loss account, but should always be viewed in conjunction with a monthly Cash Flow forecast.

Control of cash flow is vital. Only if you know your inflows and outflows will you avoid a nasty shock somewhere down the line.

Net Profit is not the same as Net margin

This sounds pedantic, but Net Profit is a cash figure and Net Margin is the percentage expression of that profit as part of total revenue. Bank Managers are seldom impressed if a business owner does not appear to realise the difference!

Net Profit is not the same as Gross Profit

Sometimes, we hear business owners saying that they are profitable when they are not. This is because they see Gross Profit as the ultimate measure of profitability, when in fact it only measures the profit after deduction of the direct operating cost of achieving sales. Lurking further down lie all the other overheads, which must be deducted to arrive at a true Net Profit measure.

Debunking the fears surrounding ‘EBIT’ and ‘EBITDA’

These terms are sometimes confusing as they can prompt business owners to think that there are other measures of profit that they ought to know about; when in fact they just consider profit in a slightly different way. They are useful when comparing different companies in the same industry, as they strip away costs that vary from company to company – often handy when making comparisons with competitors when assessing relative strengths and weaknesses – not to be regarded as Something Completely Different.

Definitions:

EBIT is the operating earnings of the firm before interest and tax. It is a measure which indicates the firm’s earning capacity from regular operations and is helpful in analysing the company’s operational efficiency, ignoring interest and income tax expenses. As these two variables differ from firm to firm, it provides an ideal measure to compare performance with competitors.

EBITDA is an acronym for Earnings before Interest, Tax, Depreciation and Amortisation. It signals a company’s profitability and performance on the basis of operating decisions, ignoring the impact of non-operating factors like cost of capital, non-cash items and tax implications. As these factors vary from company to company, it allows the users to analyse the profitability of the company using an ideal performance metric. In this way, the comparison can be easily made between different firms of similar size and nature.

The true profit of a business is the only measure that matters when it comes to long-term success and – ultimately – successful exit, when it is the crucial valuation measure. Important to get it right from Day One.

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