Picture this:
In Entrepreneur Land, there’s a passionate business owner, pouring their heart and soul into their business.
Great product? They got it.
Customer satisfaction? Amazing.
Extremely-long-hours-that-lead-to-burnout-but-who-cares? Check!
But still… when it comes to the bottom line… the numbers simply aren’t adding up 😱.
Not saying the passionate business owner is you, but in case it is, we prepared a quick and easy guide to profitability.
As soon as you’re done reading – POOF! Your business will be profitable…
… yeah, no, just kidding, this is not financial magic. Just some knowledge, so you can understand, measure, and improve your profitability 😉
No, no it’s not. Contrary to popular belief, these are two distinct words, with different meanings.
Cash flow is the money moving in and out of your business at any given time, while profitability is the amount of money left after subtracting expenses from revenue.
You know… the amount of CASH that FLOWS and on the other side, how profitable your business is.
People usually believe that a profitable business won’t encounter cash flow problems, but that couldn’t be further from the truth.
Let me give you a quick, very serious example:
Making money doesn’t mean you’re making a profit, simple as that. For example, you may have $1000000000000 on your account, but that does you no good, if you owe $2000000000000 to your vendors for the services they already rendered.
On the other hand, you could have a depressing $0 on your account and STILL be profitable (maybe because you pre-paid your vendors and expect a payment from a client).
In conclusion, the amount of $$$ shows your cash flow, which is TOTALLY different from your profitability.
Now that we got that out of the way, I want to give you a new perspective to view profitability.
An unprofitable business is not only a business that incurs losses… but also any business that gives you a lower return on invested money than another business or financial instrument with similar risks. — Hmm… [pause] Then why am I engaged in this business?
In which case, you should ask yourself…
… Hmmm [brief pause for dramatic effect], is my business the asset that could give me the most profit, or am I running it for no reason whatsoever?
To measure your profitability, we’re going to need some indicators, profitability indicators, if I may.
These indicators show us how well a company is using its assets to generate profits. Here they are…
Net Profit Ratio shows you how much money from revenue actually ends up in the company’s pocket. Sweet and simple
Measures how well you use both borrowed money and your own money to generate profits Basically, how much profit you make from your capital. Yes… it’s useful for attracting investors 🙄.
Little scenario: Let’s say you own a bakery, invest your own $10,000 (your equity), and borrow $10,000 from your neighbor (your debt.) Now, suppose your bakery makes $6,000 in profit before taxes and interest (your EBIT). After paying $1,000 in interest, you’re left with a $5,000 net income.
If your ROCE is high (e.g. 30%), it means you’re efficiently using all capital – so borrowing more to open a second branch or buy a new oven might be a good idea.
It also means that reinvesting profits into growth (e.g., marketing, new equipment) could lead to even greater returns. However, if it’s low, it might be better to hold off on reinvestment and distribute profits (dividends) to yourself or improve efficiency first.
And as we said, a high ROCE even helps with investors. It indicates strong operational efficiency, which would make your neighbor’s rich uncle very interested in investing in your bakery.
Similar to the last one, but this focuses only on the profit made from your own investment. In the above example, ROE would only evaluate how efficiently you use your $10,000 of equity (your investment).
A high ROE shows that keeping profits in the business benefits you as the owner. If ROE is low, you may want to withdraw profits instead of reinvesting.
Bonus point of using ROE: If the rich uncle sees a high ROE, he’ll know that your bakery generates strong returns for its owners, so he’ll know he could earn good dividends by investing in you.
The ROE also helps you answer the question: “Should I keep my debt or pay it off?” If your ROE is high (e.g., 50%), keeping the debt might be better because it’s helping you leverage profits. However, if the debt cost (e.g., 10% interest) is cutting too deeply into your profits and lowering ROE, you might decide to pay it off.
Ahhh, the one we all actually get. Well, it compares the amount paid for an investment to the amount earned! Example: You buy a new oven for $5,000, which allows you to produce 50% more bread, increasing your annual profit by $2,500.
After 2 years, the oven will begin to have a positive ROI. When you’re unsure what to invest in, the ROI helps you prioritize, since the highest ROI investment is generally the most profitable.
If ROI is very low (<10%), you might want to reconsider the investment altogether.
There are more ratios you can look at, but this article isn’t solely about metrics. Here, I just wanted to give you an idea of what you need to look at.
If you want to go on a deeper dive (which is still quite shallow simply because of how simply we explain these tough topics), you can read our Key Financial Metrics article
As you would think, there are a LOT of factors influencing profitability. Let me give you all of them in one place, so you can think about how each of these applies to your specific situation…
Obviously, your pricing has quite a lot to do with profitability. The goal is to charge as MUCH as you can while still being competitive. You know, you can’t really charge $1000 per protein bar (unless it’s made of unicorn dust).
Be aware of what is going on in your industry as well as what your competitors are charging. Not just so you don’t overprice yourself – I also don’t want you undermining your worth. So do some research, read our Pricing article, and set the perfect prices.
These are the costs that fluctuate with revenue, like labor, utilities, and raw materials. The more you sell, the more materials you’re going to need. The more revenue you generate, the more you’re going to have to pay to your revenue-share contractors.
It’s not just more money, less problems.
For example, if you choose to add a large number of clients in order to increase profit, you have to consider the associated costs. How many more people are you going to have to hire? How much money are you going to have to spend to deliver the product/service?
Fixed costs are the bills that show up whether you’re making it rain or just praying for a drizzle—think rent, insurance, and those pesky software subscriptions you forgot to cancel.
You have to be very familiar with these costs because they will play into… drum roll… price points! When setting a price, you have to make sure you’re including enough to cover those fixed costs. Obviously, I know, but not everyone is at your level yet!
A monopoly allows you to set prices by closing your eyes, randomly hitting the keyboard, and calling it a day. You probably don’t have a true monopoly, but the more innovative and creative you can get, the closer to it you can come.
On the flip side, if there’s a lot of competition and everyone else sells the same thing as you, you might not be able to charge and profit very much.
If you remember elementary school, you know about supply and demand (If not, no judgment—we’ve all slept through a class or two).
Strong demand leads to higher prices and profitability, of course. Is your product or service in high or low demand?
This refers to all costs that affect a company’s profitability, including labor, rent, raw materials, exchange rates, etc.
There are tons of things that can affect the mentioned costs. Some of them are market conditions, supply chain issues, the economy, or technological inefficiencies.
You can’t really control these, but you should be aware of how external events might change your costs, and therefore, change your profitability.
This means you’re charging different prices to different clients based on their willingness to pay.
Some might question whether this is ethical or not, but here at Eightception, we don’t judge… as long as it’s legal. Actually, we don’t care, as long as it boosts that bottom line.
Businesses, especially those in their early stages or experiencing rapid growth, often operate in a constant state of crisis. This is where you need to get into “Founder Mode” 😎.
In this mode, you keep in mind your vision and potential – so you’re able to make rapid decisions even in the face of uncertainty and turbulent periods.
How hard you’re able to keep pushing even if profitability isn’t high is something that’s going to impact your profitability heavily.
Your #1 goal doesn’t have to be profit – it can also be market share. Maybe you want to reinvest all the money you make and not profit for some time, which is called the ‘growth-at-all-costs’ model
Everything before this was warm-up – now you’re at the ‘meat and potatoes’ part of the article. Sounds threatening, I know.
What use does all of this theory do if we don’t tell you how to improve your profitability?
So, idea #1…
One good tactic you could try to increase profitability is cross-selling. If you’re offering Service X, and you know Service Y complements it beautifully, why not offer both?
You can also play around with special deals and discounts, that’s always a good way to hype people up and get them to use their fancy little credit cards. Don’t be afraid to put a little discount on a genuinely good deal.
Also, invest in your marketing. If you don’t want to think about that scary M-word too much, we’ve got you covered. Read our article on easy marketing for people who despise it
Now, let’s talk about decreasing your cost.
You might think that reducing some costs here and there doesn’t make much of a difference, but trust me, it does add up. Try to always get high-quality supplies in order to minimize wastage and negotiate good prices with your suppliers (and be on the lookout for better ones).
What’s more, a wise man once said:
“To earn from what you do, you must first stop doing what does not earn you money.”
If you want to maximize profitability, you’re going to have to prioritize ruthlessly. Try to identify and eliminate the activities that don’t directly contribute to revenue generation. Often, we don’t need more goals and more tasks, we just need to focus more on fewer goals and tasks.
Actionable step: Think about delegating and streamlining operations, or even discontinuing unprofitable products or services.
When thinking about profitability, everyone just talks about short-term financial performance. You might want to calculate your customer lifetime value (LTV) and try to increase that as much as possible.
Profitability isn’t just a “how are we doing right this second” thing…
… wait, you don’t know how to calculate LTV? Oh, well… If only someone offered a course on finding the metrics that truly matter, calculating them, and applying them to your startup…
In our Unit Economics Course, we teach you how to turn the math in your favor with real-world stories and examples, feel free to check it out – no pressure.
This article has a lot of information inside, I get it. We recommend you read it with a pen in hand and note down how each and every aspect of profitability impacts your business. That’s the way you’ll get the most amount of clarity. Here’s a little recap though:
Email subscription is available ONLY TODAY (oh, okay, and tomorrow).
Surely, we respect your inbox! Unsubscription works every day.
