This is the business world equivalent of the question “how is life”. There is a lot of scope for the receiver to respond but “okay” or “pretty good” doesn’t cut it in the business world, so what should you consider if asked the question?
If you’re a start-up then you probably answer that question around proof of concept outcomes, website/app visits, client numbers or potentially sales with no regard to profitability.
However, once a business is established, a primary goal is to generate a profit (simply an excess of revenue over expenses) so a simple measure to consider is absolute profit, or the $ amount of profit generated over a period. Ask yourself: is that amount sufficient to sustain the owners and any finance obligations? Is the amount growing or decreasing? Will it sustain investment required to grow?
A word of warning: business owners often confuse profit with cash flow. For some businesses these tend to be quite similar but for others, particularly those that offer terms to their customers or invest heavily in stock or capital equipment, they can vary dramatically, so if your drawing funds out of the business on the basis of profits and cash flow is lagging, typically funded by your creditors in the early days, you may be setting yourself up for a nasty shock.
A more evolved consideration is relative profit, but relative to what. The most common calculation is profit related to revenue and expressed as a % - 20% of revenue as an example – which allows you to start thinking about how efficient your business is (e.g. for every $1 of revenue we generate, we spend $0.50 on staff and $0.20 on overheads as an example). If you can access industry data, a comparison to your peers is very valuable using this type of metric.
Speaking of efficiency, measures such as staff numbers relative to units (widgets produced, managed or revenue) are effective ways to monitor productivity and drive improvements in profitability.
A more sophisticated consideration is return on investment (simply, profit divided by a measure such as the initial investment made by owners, net assets or alternatively the market value at a point in time). This calculation will provide you with an outcome expressed as a % that can be reviewed with risk in mind. As an example, a term deposit with an Australian bank is relatively minimal risk and requires minimal effort from the investor and returns around 2.5% at the time of writing whilst returns from property investments and direct shares in the form of rents and dividends respectively can be in the range of 5%-10%.
One variable that shouldn’t be ignored is the notional value of time invested by owners. This cost often isn’t formally reflected in a businesses profit & loss statement but for the purposes of assessing the value of the business and a return on that investment, the market value of those efforts should be included.
If you don’t measure it, you can’t manage it. Setting expectations and then regularly measuring your performance against those expectations and adjusting course as necessary is a foundation for business improvement.
If you’d like to discuss this topic further, please contact our Principal at cam@righthandadvisors.com.au.
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