There are probably many reasons you chose to start a business. Unless you are a technocrat, pouring over financial statements wasn’t one of them. However, it is important to pay close attention to key financial ratios, such as your profit margin.
According to U.S. Bank, 82% of business failures are caused by poor cash flow management. While a number of factors can lead to cash flow problems, poor profitability is one of them.
What is a profit margin?
Your profit margin is the ratio of your profit to total sales. You calculate your net income (your “profit” in layman terms) by subtracting your expenses from sales. After calculating your net profit, you calculate your profit margin by dividing it by your total sales. You can also use a profit margin calculator to simplify the process.
Why is monitoring your profit margin important?
Too many entrepreneurs focus entirely on their total profit. This is a big mistake, because they may be overlooking problems with efficiency.
As you can see from the equation above, both total expenses and revenue affect your profit margin. Companies can improve their profit margin by reducing important overhead expenses, such as:
- Labor costs
- Inventory costs
- Energy costs
They may also improve their profit margin by improving revenue. This can be accomplished in a variety of ways, such as improving sales conversion rates, reducing delinquent accounts receivable and finding cost-effective ways to improve marketing efforts.
It is always a good idea to compare your profit margin against the industry average. If most other firms in your industry have profit margins of 20% and yours is only 15%, then you may have a problem.
What your profit margin does and doesn’t tell you:
While a high profit margin is generally a good thing, it isn’t everything. You need to consider a number of factors while analyzing it.
Companies with higher profit partitions aren’t always more successful
Some of the largest corporations in the world operate on slim profit margins. Walmart’s profit margin is only 3.12%, but it is one of the most profitable companies in the world.
Profit margin is very considerably by industry. Also, within a given industry, successful companies may have lower profit margins, because they may pay more money to scale resources.
For example, a freelance web developer may have nearly a 100% profit margin, because they have almost zero expenses. On the other hand, a major development company may only have a 20% profit margin, because they have to pay for a large facility and higher team of developers.
Although the freelancer has a much higher profit margin, the agency is generating far more revenue.
Here’s the basic rule of thumb: if two companies have comparable revenue, the one with a higher profit margin should be deemed more successful. However, you can’t make the same assumption if the company with a lower profit margin is generating for more revenue, because the lower profit margin maybe a trade off with higher economies of scale.
Companies with higher profit margins face lower risk
Regardless of the amount of revenue generated, companies with lower profit margins always have greater risks. A sudden surge and energy costs, a state minimum wage hike and other sudden increases in expenses could eliminate profitability.
While companies with higher profit margins aren’t necessarily better managed, they always have less risk.
Companies with low profit margins may need financing in slow periods
Every company will encounter periods where revenue drops. Companies with lower profitability may need to seek third-party financing to meet their expenditures, while waiting for the market to improve.
High profit margins may mask problems with financing long-term investments
After investing in long-term capital, you may have a higher profit margin if you took out long-term financing. Unfortunately, this doesn’t tell you much about the long-term profitability of your business, because you will have a lower loan repayment amount extended over a longer period of time. This is why companies financing vehicles and equipment through companies like Rob Sinclair Equipment should consider the different financing options and run a present-value analysis on their debt to see which makes the most sense.
Poor profit margin doesn’t tell you where to cut expenses
If your profit margin is significantly lower than competitors with similar revenue, you probably have a problem. While your profit margin can indicate a problem, it doesn’t offer any solutions on its own
You need to do the following: look at all of your expenses and identify unnecessary overhead to eliminate and find out if your sales strategy can be improved to boost revenue.
