Financial Metrics for Small Business
As a small business owner, it is important that you periodically access the financial performance of your firm. Understanding the financial health of firm allows to you further exploit areas of strength and to tweak areas where you see weaknesses.
While most small business owners do calculate their profit and losses during the tax season, it is important to note that at that point, it is often too late to make meaningful change to improve the financial outcomes of the business or even yourself from a tax efficiency point of view.
Measuring Financial Health.
Before delving into our series on which financial metrics you should care about as a small business owner, we will start by explaining and clarifying some metrics that a lot of small business owners often conflate.
Revenue vs. Profit
A lot of small business owners often judge the success of their business by how much goods/services they sold in the past year. From a financial accounting point of view, that is simply the top-line or the revenue earned. It is a good measure, but not a very accurate measure of the success or wealth creation potential of the firm. A reliable measure is the difference between what you earned and how much it cost you to earn that revenue. This is known as profit. The profit earned by your business is what accrues to you as an owner after all the associated cost of earning the sales has been deducted. There are different layers of profits (income): from gross profit, to operating profit, to before tax profit, and finally after tax profit (also known as net income or bottom-line). A sample template for an income state can be found on this link.
Irrespective which of profit measure you are calculating, you can see that profit is simply sales less the sum of the cost component included in the profit measure.
Profit = Sales – sum (cost components)
An important insight you can gain from the expression above is that there are more than one way to improve the profitability of your business. For example you can improve it by:
- Growing revenue proportionally with cost. (Dollar wise increase).
- Growing revenue proportionally faster than cost. (Dollar and percent wise increase).
- Keep revenue the same and reduce cost. (Dollar and percent wise increase) .
- Reduce cost at faster rate than the rate of the reduction of revenue. (Dollar and/or percent wise increase) .
The last bullet point shows that it is even possible to improve profitability in difficult sales periods, if you can figure out ways to reduce cost. This will be mostly through improvement in efficiencies.
Please click contact us to learn about how we can help you craft a personalized financial strategy
Taxable Income vs Income Statement Profit
Tax time often bring joy, and in some cases consternation to business owners (depending on whether you are getting a refund or you owe money to the IRS). One of the reasons for the confusion is that financially, a lot of business owners often pay themselves salaries as employees of their firm. IRS on the other hand, sees you as the firm (sole proprietor or a pass-through shareholder) and so imposes taxes on income that accrues to you, net any expenses you incurred during the years (Taxable Income).
So which one of these approaches is the best way to assess the performance of the firm? Actually, they are both important. Taxable income is important from crafting a tax efficient financial strategy for yourself as a business owner, while financial profit is an important measure of the wealth creating potential of your firm. If your business is still profitable after paying yourself a fair wage, then your business is on its way to helping you increase your stock of wealth.
