What Profit Goals Do I Need to Set for My Business?
By Caroline Somba, CPA, MBA | Founder, Topspin Finance | August 29, 2023
Raise your hand if you included ‘Grow your business’ in your 2024 Vision Board. Like any keen business owner, you’re keeping an eye on your numbers. But sometimes it isn’t easy to understand exactly what those numbers mean, or what you should be working towards.
Statics have shown that more than 50% of startups fail in their first 5 years and 38% of those fail because they run out of cash.
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.
Look at gross profit over revenue to get a more accurate picture of your business
I see a lot of small business owners talk primarily about revenue when talking about the performance of their business and gross profit or gross margin almost never comes up in the discussion.
Understandably so, this is a common mistake among business owners to look at the wrong set of numbers when setting goals for their business.
Looking at revenue alone can give a misleading impression of your company’s value as well as the overall financial health of your business. When setting profit goals, we recommend using your gross profit and gross margin numbers instead.
For clarity purposes, Gross Profit is a dollar amount while Gross Margin is a percentage (%).
Gross profit (GP) = Revenue – Cost of Goods Sold (COGs)
Gross Margin (GM) = (Revenue – Cost of Goods Sold (COGs) / Revenue) x 100
Cost of Goods Sold (COGs) or Cost of Sales (for service businesses) is the direct amount of money it takes to manufacture your products.
COGS = raw materials costs + labour costs + all other direct costs to make the products sold in the period
We cannot talk about Gross Profit without emphasizing the importance of understanding your cost of goods sold or cost of sales as this is the first line a banker or a potential investor looks at to see if your business is performing well.
Understanding your Gross Profit is core to answering the question ‘Is your company making money?
How to set SMART Profit goals for your business
It’s common in the accounting world to compare gross profit margin with industry average which brings the question – How are your competitors performing?
Statistics Canada website is a good starting point for profitability analysis across various industries.
Having an understanding that it’s about profit, not revenue and also having an idea of how your peers in the industry are performing, you can now go ahead and set profit goals for your business.
This exercise can be done through simple budgeting or forecasting and I’m going to walk you through it step by step.
On a high level, list down your revenue and your cost of goods sold or cost of sales to arrive at your gross profit. Take it a step further and calculate your gross profit margins.
The higher the gross profit margin percentage, the more viable your business is and the more likely it is to survive and put you on the road to success.
Take the exercise a step further and calculate your operating profit margin.
Operating Profit = revenue – cost of goods sold – operating expenses
Operating expenses refer to expenses that keep your business up and running. Expenses like rent, payroll, marketing, office supplies, etc.
For a more accurate picture, calculate your Operating Profit Margin.
Operating Profit Margin = (operating profit ÷ revenue) x 100
Now if your business is at a stage where you have a loan, you’re paying interest for and are paying taxes, take this exercise a notch higher and calculate your Net profit and Net profit Margin.
Net Profit = revenue – cost of goods sold – operating expenses – interest – taxes
Net profit Margin = (net profit ÷ revenue) x 100
What makes a good profit margin?
Whether it’s Gross Margin, Operating Profit Margin, or Net Profit Margin, a good profit margin depends on your business growth goals.
If you plan to take on investors soon, need financing in the future, or want to expand your services, you’ll need to forecast and work on increasing your margins.
And if by now you’re thinking ‘I hate accounting’, don’t worry, you’re not alone. A lot of business owners, especially those who don’t have a business background are feeling the same way.
Congratulations on making it this far! The next part is going to be exciting even for those who loathe Accounting.
Don’t forget to turn your profit into cash
Your business looks profitable on paper but there’s no money in your checking account. Or your Profit & Loss statement is showing a negative profit but your business is still up and running… at least in the short term.
The timing of income and expenses is imperative and understanding and managing revenue conversion to cash while being tough on your aging accounts and managing your vendor payment is critical.
Running out of cash is disastrous. Cash flow issues are sure to damage your relationships with employees, vendors, and even clients while leaving the business owner stressed out and on the verge of closing.
One of the ways you can ensure you don’t run out of cash is by closely monitoring your Accounts Receivables (AR). Set up systems to automatically collect AR for you while you focus your time and energy on strengthening your gross profits. In an ideal world, collecting your payments upfront automatically would be the most optimal.
Another way to manage your cash flow is through Accounts Payable (AP) management. In Business School and any Accounting class, you’ll be told to always negotiate with your vendors to delay payments as much as possible.
We always advise business owners to include negotiating with suppliers in their Year-End checklist. Make sure you have the best deal you can get in terms of price and/or payment terms.
Inventory management is another way you can manage your cash flow. Be smart with your purchases. Purchasing in bulk to take advantage of some discount may tie in your cash flow therefore it’s important to strike a balance in your decision making.
Setting financial goals is not as straightforward, especially when doing it for the first time. However, having no goals at all or setting unrealistic goals is like steering a ship in the dark. Think about how much value you could be getting with the same revenue number but a higher gross margin. We see a lot of opportunities for small business owners.
As a business owner, you need to be good at three things – being passionate about your product/service; being good at accounting/managing your books; and marketing/selling your goods and services. Unfortunately, no one is good at all three.
We can help with your accounting and bookkeeping. Topspin Finance is focused on making sure small business owners are not spending time stressing about their finances and taxes and they’re comfortable and confident we’re taking care of it.
About the author:
Caroline Somba, CPA, MBA founded Topspin Finance, a 100% cloud-based firm providing full-charge bookkeeping, tax filing, and fractional CFO services for small businesses across Canada.
With 12+ years of experience in Accounting & Finance managing billion-dollar portfolios for some of the most respected Fortune 500 companies globally, Caroline founded Topspin Finance to use her knowledge & expertise to help small businesses thrive and grow by anticipating client needs and offering proactive advice to aid informed decision making.
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