Profitability and Sustainability: Maximizing Financial Gain Over the Long-Haul
We have all heard the old saying “Work smarter, not harder.” But what does that really mean? Entrepreneurs seem to work all the time. There is no such thing as simply working a 40-hour week. We would like to think we work smart. But do we really? Are we as efficient as we can be? Are we making the best choices for our businesses in order to maximize our efforts? The answer is: not always.
I work with many clients who work crazy hours and produce a lot of work. Unfortunately, they continue to see less than the desired profitability. Working long days and late hours, only to bring home just enough to pay the bills. Stressing over whether they have enough cash for next week’s payroll. Wondering where they will find the next client. These worries are mentally exhausting. And can make the most die-hard entrepreneur question whether they have made the right decision when opening their own business.
Here is where profitability and sustainability analysis come in to play. For this article, profitability means just that…do you realize the maximum financial gain based on your business’s efforts and revenues? Sustainability refers to having your business be profitable for the long-haul.
There are a few key areas of any business that should be looked at if the business is under performing. Although each area impacts both the profitability and sustainability of a business, the depth of the impact will vary from business to business. This article will not provide the answers to greater profitability or sustainability. Instead, the article will get you thinking of the specific factors that impact the profitability and sustainability of your business, or your client’s business.
Expectations: We need to ask ourselves if we have realistic expectations and goals for our businesses. We may be in an industry that has historically low profit margins, but we are expecting something different. For example, according to Forbes magazine, liquor stores have an average net profit margin of only 3.4%. Therefore, if we are thinking that our liquor store is going to be making a net profit of 7%, and we base our business decisions on our assumption, we will run into trouble. It is important to base our expectations on industry averages. The good news is, Forbes ranked accounting, tax preparation, and bookkeeping service businesses as one of the most profitable, with a net profit margin of 19.8%
Management: Another key factor when reviewing profitability and sustainability are the qualifications of management. I do not know anything about operating a liquor store. I am not sure the best places to go for the best prices on my inventory or supplies. I am not sure what products sell faster than others, and what products sit on a shelf gathering dust. If I opened a liquor store, chances are, due to my lack of experience, my profit margin would be a lot lower than 3.4%! It’s very important that management understands the industry they are working in. I recently met with a new client. Nice guy. Very smart. He had a master’s degree in taxation and retired from his job of 25 years with the IRS so he could open his own business. I thought for sure he was going to go into practice and end up being a competitor of mine. However, he wants to open an auto repair franchise. When consulting with him, I questioned his management ability within the auto industry and his experience working with a franchise. Although a very intelligent man, he will struggle with management unless he has someone with appropriate management experience working to guide him along the way.
Internal Policies and Procedures: Our example above is an appropriate segue into this section. If our client had stronger internal procedures, he most likely would have identified his reduced profitability sooner. Internal procedures can be considered a “how-to” guide on completing tasks within an organization. I am not referring to financial controls, which we will discuss later, but simple procedural guidance. For example, in the case of the marketing company, what procedures were in place for an employee to follow, when faced with a change order from a client? How would that procedure impact billing and scheduling? Is it the company’s policy to allow staff to work on a change order without approval from a manager? Or better yet, what is the policy on staff training or ensuring staff have the proper skill set for a project? However, policies and procedures aren’t just for customer projects or services, but also for administrative issues. What is the policy for ordering office supplies? What is the limit on an expense before it needs a manager’s approval?
Financial Policies & Procedures: These types of policies and procedures focus on the financial aspect of an organization. They can include, but certainly, are not limited to; petty cash, segregation of duties, accounts receivable, invoicing, purchasing and financial statement review. All of these play an important role on profitability and sustainability. Accounts receivable is one of the most common issues I see when reviewing a company’s policies and procedures. The issue being, they don’t have a policy! Small business owners are often running non-stop securing the next client, promoting their business, or providing services, that they often overlook their receivables. Old receivables have a habit of turning in to uncollectable the older they get. Having a policy that states receivables will be reviewed weekly or monthly, helps mitigate the risk of them becoming uncollectable. Tying up resources in receivables has a negative impact on the availability of cash. Not having enough cash, can cause additional debt, which can lead to additional interest or finance expenses. In a nutshell, without having a proper accounts receivable policy, a small business could not only experience higher bad debt but increased financing expenses. All of which negatively impacts profitability and sustainability.
Review Industry Standards & Ratios: There are a plethora of resources for finding industry standards, trends, and ratios. A wise business owner compares their performance to others in their industry, region, and class. Determining which ratio is more important or has more of an impact, while varying from business to business. Listed below are some common profitability ratio used.
Profit Margins: There are a variety of common profit margins that can be used to measure profitability. These include gross profit margin, operating profit margin, pre-tax profit margin, and net profit margin.
Gross Margin = Net Sales – Cost of Goods Sold
Gross Margin Ratio = Gross Margin / by Net Sales
Profit Margin Ratio (aka Return on Sales) = Net Income / Net Sales
Return on Asset: This ratio compares a company’s assets with its ability to generate sales and profits. The idea is that the more assets a company has, the more sales and profits they should be able to generate.
Average Total Assets = (Beginning of Year Total Assets + End of Year Total Assets) / 2
Return on Assets Ratio = Net Income / Average Total Assets
Return on Equity: This ratio focuses on the business’ ability to generate a return on owner/shareholder investment in the company.
Employed Capital = Total Asset – Current Liabilities
Return on Capital = Net Operating Profit / Employed Capital
Return on Equity = Net Income / Shareholder Equity
Pricing Structure: This can be a tough one to get right, especially within service industries. Small price increases generally will not affect the sales of your product or service. However, you must start at the right price to begin with. Too high, and sales suffer. Too low, and profitability suffer. A tried and true method of determining price is shopping around. We need to act as though we are a consumer of our own products/services. What are our competitors charging? Can we match those prices and still reach our profitability goals? What price structure do we want to use? For example, tax and accounting firms have several different structures that are used. Some charge by the hour. Some charge by the form. Some charge by the project. Each option has its’ pros and cons. We need to consider all factors and select the one that works best in our business. I worked with a client who developed an online social platform for cities and towns. We discussed a lot of price structures; a set price, a price based on product add-ons, and more. We ultimately went with a price based on the population of the town or city. The client, who originally thought she would price the product at a flat rate of $50,000 per year, is now charging $3 per resident. This yields a great deal more revenue than a fixed price ever could. Those towns with a higher population, who would by nature need more technical support, now pay more than smaller towns who require less. A fair pricing structure for her customers, and a more profitable model for her business.
Revenue: We cannot talk about price without talking about overall revenue. Revenue is the driving force for our bottom line. We can come up with the perfect price for our product or service, but if we are not generating revenue then we are going nowhere fast. What revenue goals do we need to reach to meet our profitability goals? What kind of growth in revenue do we want to see in the next year, next five years, next ten years? When we think of Revenue, we must also consider the assets we have at our disposal which can create revenue. Assets can be both machines and equipment, as well as people. For example, let us assume we have four tax preparers in an office, each working 40 hours per week, 50 weeks per year, that equals 2,000 hours per employee, per year. Since the staff needs to have time for non-client work such as checking emails, administrative tasks, or continued education, we are going to assume each staff only has about 1,500 hours of time available for client work each year. We bill our customers $200 per hour. After doing the math, we should have calculated about $1.2M in revenue (1,500 x 4 x $200 = $1,200,000). If we are not budgeting that amount for revenue, we need to understand why. If we are budgeting that amount, but not realizing the full $1.2M, we need to analyze why. We are paying our staff to be here and be productive. Our we expecting too many billable hours from them? Are we eating time because our staff took too long to complete a job? Is our staff sitting around with not enough work to do? There are a great deal of factors that impact our revenue goals and why we are or are not reaching them.
Cost of Goods Sold: This is troublesome for any company that sells products but can be particularly troublesome to those types of companies that re-sell finished goods. Our firm works with a printing company. When the client produces a job completely “in-house”, his profit margin is healthy. However, when he has to out-source parts of a job or an entire job, his profit margin almost goes into the red. He has no control, other than via negotiation, over the price he is charged. After analyzing the source of his revenue (in-house or out-sourced), we determined he was performing too many out-sourced jobs. We had to reassess his revenue stream, and focus on the sale of more in-house projects. By reviewing the expense, it brought us back to revenue for part of the answer.
Overhead: Here we are referring to all the other expenses not directly related to producing a product or specific service. Things like rent, wages, insurance, utilities, travel, meals, and office supplies. Many businesses do review these expenditures on a regular basis, but some do not. It is very easy for some of these items to get out of control. Insurance, meals and office supplies are three of the areas clients struggle with. Usually, the struggle is because these expenses are not always monitored. $20 here or $40 there, does not seem important…until you add it all up. Some clients have not reviewed their insurance policy in years. Once they do, they often can either reduce rates or at least get more coverage for the same premiums. Our firm worked with a client who provided meals for her staff. She would buy lunch at a local restaurant and have it delivered. When reviewing the expenses with her, we determined it would be cheaper for her to purchase a full-sized refrigerator, a toaster oven, and groceries, allowing her employees to make their lunches. This simple change saved her thousands of dollars each year. Some expenses, seemingly so inconspicuous, can end up being an excellent area for savings.
Employee Productivity/Engagement: This is an important area that often goes unchecked. We appreciate our staff. I do not know of anyone who wants to start a conversation with an employee with, “Hey, you know, you’re just not producing enough.” Employee engagement, or lack thereof, can have a serious impact on a business’ profitability and long-term sustainability. According to 2017 statistics from Officevibe, at least 51% of employees are looking to leave their current job. Job satisfaction is tied to employee engagement. If 51% of our staff is looking elsewhere, how can we ensure they are as productive and efficient as we need? How can we be sure they are giving our customers the support we expect? Motivating employees is not always about money. 80% of employees would work more hours with no pay increase, for a “good” boss. Businesses statistically see a 20% sales increase when employees are highly engaged. I worked with a client who operates a profitable and successfully marketing company, with a staff of 8 professionals. Even though revenue was consistent, he saw a decline in profitability. Upon review of his employee’s time on projects, we were able to determine that his employees were not sticking to project budgets. Often going over budget by thousands of dollars. After digging deeper, we were able to determine a few key items. Some employees were not trained well enough to be able to do their job within the time budget they were allowed. Others were disengaged and had significantly dissatisfied with their job. Another factor discovered was the client made significant job order changes that increased the time required. These job changes did not go through the proper channels, and the additional work and time were never billed to the client. This exercise provided valuable information to our client. He needed to work on employee engagement, employee job training, and better communication to employees on the process required for customer change orders.
Final Thoughts: As you can see, there are many areas of a business that can and should be reviewed when considering a profitability and sustainability analysis. Which areas are more important will depend upon the industry and the individual business. How to address and correct any shortcomings will also vary. The key is to be looking at these areas all the time. A vibrant, profitable and sustainable business will go through cycles and changes. Therefore, it is recommended to review these areas often. This is not a “one and done” situation. As the business changes, so will the variables which impact its profitability and sustainability. Remember, when we work smarter, we are able to maximize our financial gain over the long-haul!
Published: Tax ProJournal, Spring 2019. National Association of Tax Professionals, Appleton, WI.
About the author: Kris Roberts is the Managing Partner at The Roberts Tax Group in Torrington, CT. She is a Professor of Accounting and Taxation at the Malcolm Balridge School of Business at Post University in Waterbury, CT. Kris also serves as the President of the CT Chapter of NATP, and as a State Volunteer for NATP. She is a doctoral candidate at the University of Phoenix, working on her research involving small business tax compliance. Kris can be reached at KRoberts@rtg.tax