How To Make Sense Of Your Profits
Profit figures without context are meaningless.
As we’ve previously discussed, making $80,000 in profit is neither good nor bad, not without some more understanding of the circumstances.
For example, a large company that employs 40 staff would be concerned about such a low profit, whereas a sole trader would be delighted.
It also depends on the amount of risk that was taken to achieve the reward – this reframes whether or not it was worth venturing so much time, money and energy.
What we need are some more ways of deriving meaning from our bottom line.
What We’d Do With Surplus Cash
If you had an extra $40,000 at the end of the financial year, what would you do with it?
Would you buy more equipment?
Would you increase salaries?
Would you take on more passion projects?
Would you pay down debt?
Would you set up a rainy day fund?
Would you grow your team?
Would you increase your social impact?
Would you take on more debt to grow the business?
Does the answer change if you had $100,000?
These aren’t just abstract questions, they’re the basis of your financial strategy.
Making cuts and boosting sales are both difficult, so there needs to be a reward that’s driving you.
By understanding the “Compared to what?” for your business, you’ll be able to make more informed trade-off decisions – saying no to good things in order to say yes to the best things.
Risk and Reward
Investment returns are usually measured in percentage terms, but this does not capture the full story.
For example, an 8% return from a term deposit at a bank would be incredible – you’re taking virtually no risk.
An 8% return from an index fund would be quite good, since there was a chance your investment would go backwards for a number of years.
An 8% return from a speculative venture capital fund would be disappointing, since you’d taken on a huge amount of risk, potentially losing 90% of your investment.
This is why investors typically look for “Risk-Adjusted Returns”, a level of reward that matches the investment’s level of volatility.
One way of making comparisons is to measure the “Cost of Capital” – the amount you’re essentially paying for the money.
This is determined by understanding what your money would have otherwise been doing, otherwise known as “Opportunity Cost”.
That in turn, is determined by finding something that has a similar level of risk.
For example, if I am setting up an impact investment term deposit, you’d compare it with what the other big banks are offering for the same level of risk (today that’s about 2-3%).
If I were setting up an impact investment property portfolio, you’d compare it to what other large property portfolios are returning (maybe between 4-7%)
If I were setting up a high risk early stage fund, you’d compare it to a fund that makes a lot of high risk, high reward bets (returns of 30-40%).
This ensures that we’re “comparing apples with apples”, and measuring our investment opportunity next to a fair equivalent.
ROI and SROI
This all points to the principle of “Return on Investment”, a formal way of asking “What do I get for all my money and effort?”
We measure Return on Investment (ROI) in our lives all the time.
Let’s say you’re thinking about taking up a hobby.
How will you know it’s worthwhile?
You’re mentally calculating the cost involved (dollars for classes, books, materials, etc) as well as the time, sweat, energy and frustration.
Then you’re comparing that to the joy and satisfaction you’ll get in the process, as well as valuing the end result:
"I have to do 18 months of French lessons, but then I can travel around France with ease"
"I’ll spend a lot on dance classes, but then I’ll look impressive at my cousin’s wedding"
"If I take the time to learn how to cook, I’ll be both healthier and spend a lot less on Uber Eats"
This is the same decision that you’re making as a business owner or an investor:
What’s the cost and what’s the payoff?
How much of my money, sweat, tears, emotional highs and lows are going to be needed, and what will I end up with?
A pile of money?
A valuable business?
Genuine social change?
The first metric we use is the financial ROI, calculated in excel.
Then we list the intangible costs and benefits, to make a more well-rounded decision.
For social enterprise/impact investments, we also look to understand the social return on investment, sometimes called an SROI.
In the development industry this is sometimes called “The Helicopter Test” – would we have been better off if we’d have thrown all the cash out of a helicopter above our target communities?
Most funders don’t want to put in $1m of investment to have $20,000 worth of impact.
They’re better off investing the $1m elsewhere, generating $50,000 of interest and giving out $50,000 worth of grants.
It’s hard to argue with that logic.
Therefore, we need to prove to ourselves and others that this investment creates a decent amount of impact, and compare that with what the money could have otherwise achieved.
When we look at the profitability and performance of our business, it’s important to look at a range of metrics that tell us a more complete story.
By using a variety of indicators, we can detect underlying changes and better predict the future;
- Your car might not have cost much to service, but it’s making a funny noise that makes you think something will soon require replacement.
- The scales say you haven’t lost weight, but you can run further and have better muscle tone.
- We have more customers, but not as many are becoming regulars.
By designing and monitoring the right numbers, you’ll be able to test the impact of your growth tactics, marketing campaigns and pricing decisions.
Put another way, without good metrics, it is impossible to make good choices about growing your revenue streams or cutting unnecessary costs.
We’ve already examined several useful metrics and how they are calculated, so now we’re looking to generate some “dashboard figures” that are easy to monitor.
By building these formulas into your excel spreadsheet, you can highlight the connection between your most important metrics and your profitability.
For example, you might list your churn rate, net promoter score and margin per sale, in order to explain the rise and fall of your sales.
Here are some suggestions, pick the ones that are most relevant for you:
· Cost to acquire each customer
· Cost to retain each customer
· Average spend
· Gross margin
· Net margin
· Churn rate
· Net promoter score
· Purchases per customer
Balance Sheet Thinking
We’ve previously been focusing on financial models that track your cashflow, or measure the profit/loss of a given year.
What this misses is the Balance Sheet – the summary of your assets and liabilities.
The balance sheet tells us an important story about how the the business is growing.
For example, you might have acquired a lot of assets this year, such as machinery and equipment, or intangible assets like intellectual property and valuable content.
Your cash profits might be low, but your business has become undeniably stronger.
Vice versa, you might have made a bit of cash, but your equipment is becoming outdated and your assets are decreasing in value.
On the surface your business looks good, but it’s foundations are falling apart.
For this reason, it’s worth looking at your own balance sheet, tallying up all of the value-producing assets, deducting the value-draining liabilities, and seeing how much equity you have left over.
That equity figure will give you some useful perspective as to how the business is going.
You don’t have to spend your profits for them to make your life better.
Instead, you can create cash reserves that buy you better sleep.
How many months of operating expenses should you have in the bank?
If might be 3 months, 6 months, a year – depending on your industry and circumstances.
The point is, you’re allowed to keep some cash aside.
Yes, reinvestment can help grow the business faster, but there’s also a lot of psychological (and financial) benefits to having some wiggle room along the way.
Next we'll look at the tricks and traps of financial modelling...