Like any keen business owner, you’re keeping an eye on your numbers. But sometimes it’s difficult to understand exactly what those numbers mean, or what you should be working towards. Setting solid profit goals - and generating adequate cash flow - is vital to the long term success of your business, and can be broken down more simply than you might expect.
It’s an all too common - and understandable - mistake for owners to look at the wrong numbers when trying to set goals for their business. You might be tempted to look at your revenue number to deduct how profitable your business is and plan for future actions. However, revenue is something we call a vanity metric: one that gives a misleading or downright false impression of your company’s value.
When setting profit goals, we recommend starting with your gross profit number instead. To find your gross profit, use this simple formula:
revenue - cost of sales = gross profit
Your cost of sales (or COGS for cost of goods sold) is the amount of money it takes to manufacture the products or services you sell your customers. These direct costs are something you have little control over unless you want to seriously impact the quality of your services. Because of this, gross profit is the most indicative number to tell the size of your business.
You know what your gross profit is, but you’re still scratching your head about your business’s profit goals. What’s a “good” gross profit? When should I be worried? How are other businesses performing?
The book ‘Simple Numbers, Straight Talk, Big Profits!’ by Greg Crabtree breaks down what different gross profit margins mean in an easy to understand scale:
You can find your gross profit margin using this formula:
Gross Profit Margin = Gross Profit / Revenue x 100
Like Greg Crabtree says, a gross profit margin of 10% is a solid goal to set for your business.
Once you’ve set your profit goals - and outlined some clear, actionable steps for how you’re going to achieve them - you can start considering how to turn that profit into cash. Running out of cash is catastrophic for a business; your employees and suppliers won’t appreciate it if you don’t have the funds to pay them. On top of that, the daily stress of dealing with low levels of cash takes time, energy, and focus away from successfully growing your business.
One way to avoid feeling cash-starved is by closely tracking your Accounts Receivable. You can stay on top of unpaid invoices by setting up systems to automatically chase up late payments or, better yet, make it your process to get paid up front.
Your Accounts Payable are another area where you can monitor cash flow. Set up terms with your suppliers to ensure payments are only sent when they’re due, rather than in advance. Be smart with your inventory purchases: volume buying may get you discounts, but ensure this extra cash splurge in the present won’t have any ramifications in the future.
You’re pouring your heart and soul into your business, but you can’t help feeling full of trepidation and unease. What’s around the corner? Am I heading for an iceberg that I just can’t see yet?
Financial intelligence is the best way to quell this fear and uncertainty. When you have a detailed understanding of your business's financial position plus processes and tools in place for continued success, you can move through your day with confidence. For more information on profit goals and cash, plus three more principles every entrepreneur can master, download our free Financial Foundations guide here.