Do you know exactly how profitable your business is?
Analysing profitability is deceptively simple – it’s not just about knowing how much money is coming in but also understanding where it’s going and how much remains after all costs and activities are accounted for.
Analysing business profitability is a prerequisite to effectively planning and optimising your business. Here’s how to do it.
Grasping your business’s profitability requires collecting and analysing several key metrics about your business’s income and outgoings.
To accurately analyse profit, you’ll need to gather data on sales and income, costs and other overheads.
Here are three fundamental metrics that help decode your business’s profitability:
- Gross profit margin: This illustrates the percentage of total sales revenue your business retains after deducting the direct costs of producing the goods or services sold.
- Net profit margin: The net profit margin considers what’s left after all expenses (direct and indirect) are deducted from the revenue.
- Return on investment (ROI): ROI quantifies the proportion of money returned from business investment. A healthy positive ROI suggests your business is making profitable investment decisions.
Here’s an example of how it comes together. For the sake of simplicity, let’s say your ecommerce store sells a single product – a chair.
- Gross profit margin: This is calculated as (Sales – Cost of Goods Sold) / Sales.
Suppose you sell the chair for £150, and the cost to purchase and ship each chair from the supplier is £60. In that case, the gross profit margin for each chair sold would be (£150 – £60) / £150 = 0.6 or 60%. For every £1 of sales, 60p is gross profit that can cover operating expenses and contribute to net profit.
- Net profit margin: This is calculated as (Revenue – All expenses) / Revenue.
Assume you have additional operating expenses such as website hosting, marketing, and other overhead costs amounting to £20 per chair sold. The net profit margin would be (£150 – £60 – £20) / £150 = 0.467 or 46.7%. After accounting for all expenses, this shows what portion of your sales is actual profit.
- Return on investment (ROI): This is calculated as (Net Profit/Cost) x 100.
If you bought 100 chairs for resale, your initial cost is £60/chair = £6,000. If you sell them, your net profit is 100 chairs x £70 net profit = £7,000. Therefore, your ROI would be (£7,000/£6,000 x 100 = 116.67%. This means you’re gaining 16.67p for every pound invested in inventory.
With this business model, providing all costs stay constant and you can sell your stock, you know you’ll make roughly 16.67p for each £1 invested.
Analysing your business’s financial health
Understanding your business’s financial health stretches beyond profitability metrics. It encompasses an evaluation of cashflow, operating expenses, and debt levels.
- Cashflow: Cashflow represents the balance between the money inflow and outflow. A positive cashflow clearly indicates your business’s ability to cover expenses, repay debts, and reinvest to drive growth.
- Operating expenses: These are the costs associated with running your business day-to-day.
- Debt levels: A reasonable level of debt is acceptable and can benefit a business. However, excessive debt may put your business at financial risk, so keeping debt levels in check is crucial.
A business showing positive cashflow, manageable operating expenses, and controlled debt levels typically suggests strong financial health.
Strategies to maximise profits
Increasing your business’s profitability isn’t just about boosting revenue – it also involves strategically managing costs and improving operational efficiency.
Revenue is the lifeblood of your business, and increasing it is a fundamental strategy for maximising profits. Here are a few pointers:
- Changing prices: You might be mispricing your products. Conduct a thorough market analysis to understand what your customers are willing to pay and reassess your pricing accordingly.
- Expanding your customer base: Targeting new demographics or geographical locations could increase sales. Consider marketing to untapped customer segments.
- Introducing new products or services: Diversifying your offering can cater to a broader audience and create additional revenue streams. This could involve related products or services that complement your existing portfolio.
Efficient cost management is critical to improving profitability. Here’s how you can reduce costs:
- Negotiating with suppliers: Developing strong relationships with your suppliers can open up opportunities for discounts or more favourable payment terms.
- Improving operational efficiency: Streamlining operations by identifying and removing process bottlenecks can help minimise waste and reduce costs.
- Reducing waste: Implement practices that reduce material waste, such as recycling or reusing materials or improving inventory management to prevent spoilage or obsolescence.
Enhancing productivity means you’re getting more out of your resources, be it time, money, or labour.
- Investing in technology: Technology can help automate repetitive tasks, reduce errors, and speed up processes, leading to significant productivity improvements.
- Training staff: Upskilling your employees can improve their proficiency, leading to faster, more accurate work and higher output.
- Streamlining processes: Regularly review your processes to identify any that are redundant or can be combined to save time and resources.
Making informed decisions
While it’ll take some time to find a robust, accurate formula that works for you, the better you understand profit and related metrics, the better you can strategise for growth.
By vigilantly monitoring your key metrics and continually exploring ways to enhance them, you create a more profitable and sustainable future for your business.
For more advice that’s specific to your business, get in touch.