When you’re just starting out, the sole focus of most small business owners is to generate revenues as quickly as possible. Revenues, which are also referred to as “sales,” are critical to a growing business that’s trying to gain a foothold in the market. At some point, however, the business will need to generate profits if it is going to stay in business. A business can have growing revenues each month, but, if it can’t generate them profitably, it will have a very difficult time sustaining growth. That illustrates the key distinction between revenue, which is money your business receives, and profits, which is what is left over after your business covers all its costs.
Cash flow is the lifeblood of your business. It’s possible to have strong revenue growth, and even show a profit each month, but the business could still starve itself without a steady stream of cash flow. Revenue, profits and cash flow, although interrelated, are very different in terms of their impact on your business. Let’s take a deeper dive into what you need to know to streamline your financial management.
The Fundamentals: Breaking Down Revenue, Profits and Cash Flow
Revenue is what your business earns from the sale of its goods or services. Your business can also generate un-earned revenue from interest, fees and royalties (for example, such as the interest that you earn on money in a bank account). Assuming most of your revenue comes from the sale of products or services, it is generally recorded as invoiced or as received in cash payments. If you invoice a customer for $10,000 of products, that is recorded as revenue. At the end of the month or quarter or year, your revenue is recorded at the top of the line on your income statement before expenses and costs.
Profits are money remains after subtracting the expenses incurred for producing the revenue. If it took $7,000 in staff time and core parts to produce $10,000 in goods sold, your profit is $3,000. However, it goes a little deeper than that, because you will need to calculate both “gross profit” and “net profit” to have a clearer picture of how your business is doing.
- Gross Profit: Revenue minus the direct cost of producing the goods and service is gross profit. Direct costs really refer to core parts that go into a product or the staff expenses into a service.
- Net Profit: Revenue minus direct cost of producing goods and services minus all other business expenses (like payroll, rent, utilities, taxes).
Gross profit tells you how efficiently your business is producing the products and whether you’re pricing appropriately. Net profit is your bottom line result of what the company has left over to invest in the company.
Cash flow is the amount of money your business has on hand at any time resulting from inflows and outflows occurring each day. If you invoice a customer for payment in 30 days, you will have generated revenue. Yet you won’t have cash flow from the transaction for a month – or until that client pays. That is why managing cash flow, which includes receivables and payables, is critical to ensuring you have sufficient cash on hand to pay the bills.
What Your Income Statement Tells You
Each day your business executes a number of transactions – bills are paid, money is received – creating a flurry of activity that makes it difficult to know where you stand. The income statement, which should ideally be prepared monthly, quarterly and annually, tells you how you are doing within a specified period. This will tell you if your revenue or sales are trending up or down. It will also tell you how much money remains at the end of the period after deducting all costs. More importantly, the income statement tells you how much money you have to pay debt and grow the business.
Using Key Ratios to Interpret Your Income Statements
By converting the information in your financial statements to ratios, you can more quickly identify your business’ strengths and weaknesses and make more informed business decisions. Ratios are used to examine the current performance of your business in comparison to prior time periods; and they can help you gauge how well it is doing in comparison to other businesses in your industry. The good news is ratios are not overly complex to calculate or interpret.
Key Income Statement Ratios
Gross Profit Margin: Your gross profit margin is an indicator of how well you are pricing your products. It’s calculated as follows:
Gross profit margin = (revenue – cost of goods sold)/revenue
Net Profit: The net profit ratio is the most important indicator of financial health, which is the cash that shows up on your bottom line each month after you’ve paid your bills. It’s a simple calculation:
Net profit = total revenue – total expenses
As an example, if your sales revenue for the month totaled $20,000, and all of your expenses (rent, payroll, inventory, etc.) totaled $13,000, your net profit is $7,000. The net profit represents cash available after expenses; however, for sole proprietors or partnerships, it also represents the income they can take from the business. It’s important to generate a net profit that will cover the owner’s salary while building toward a cash reserve.
Net Profit Margin (NPM): This metric converts your net profit into a ratio that can be used to identify important trends in your business. Your NPM tells you what percentage of your revenue is profit. Again, it’s a simple calculation:
Net profit margin = net profit/total revenue
If your sales revenue for the month totaled $20,000, and your expenses (rent, payroll, production, etc.) totaled $13,000, your net profit margin is 35 percent. Using NPM, you can better identify trends, and project future profits.
What the Cash Flow Statement Tells You
The cash flow statement tells you exactly how much money is coming in and going out of the business, and how much is on hand to pay daily expenses and immediate debt obligations. It will inform you of your working capital needs in anticipation of increasing sales when you need additional material or labor. It can reveal any deficiencies your business has in generating and maintaining cash so you can work to overcome them.
Generally, ratios are not used for analyzing your cash flow statement, which is more of a bottom line calculation of how much cash you have or will have in the near future.
Revenue, profits and cash flow are all key indicators of how well your business is doing; but, in terms of managing your business for growth, one is no more important than the other because all of them have to work in sync for sustainable growth. It may all start with revenue, but managing productivity and pricing for profits, and managing cash flow to be able to pay the bills are equally critical for long-term success.
Which financial details do you find most helpful in managing your business? Let us know in the comments below or join the conversation on one of our social media channels.