Here’s Why Your Business Is Going Broke When It Looks like You Are Breaking Even

Here's Why Your Business Is Going Broke When It Looks like You Are Breaking Even

Are you living the dream yet?  OK, so what exactly is the dream of the small business owner/entrepreneur?  Of course, each dream is individual and unique, but all have some common ground.  This post is an introduction to what is likely the most common ground that all small business dreams share—financials.

So, are you making a profit?  Easy to measure…right?  Here’s the traditional formula that we most commonly use:

Sales

Less (minus): Cost of Sales

Equals: Gross Profit

Less: Operating Expenses


Equals: Net Profit (before taxes)

Note:

Although the above terms can be defined in much greater detail, here is all that you need to know about each in order to understand the problem and take steps toward consistent profitability:  

Make these calculations for either a month, a quarter, or a year of doing business.

Sales is simply the amount of income/revenue that you receive from the sales of your company’s goods, and/or services in a given period of time (month/quarter/year).

Cost of Sales is how much it costs you to produce/deliver those same goods/services to your customers for that same period of time.

Gross Profit is how much of that income/revenue is left over to pay your other costs of doing business.

Operating Expenses are those “other costs of doing business”, such as rent, utilities, salaries, interest on loans, etc., for the same period of time that you produced and sold goods/services (month/quarter/year).

Net Profit is the amount of money that you have left over to pay your taxes, pay yourself, pay down loans, re-invest in the business, pay back investors, etc.

If your Net Profit figure is zero, this is called Breaking Even: no profit, no loss.  If your Net Profit figure is negative (red), it is clear that you are not making a profit.

If your Net Profit figure is positive (black), this indicates that you are making a profit. What if your Net Profit is positive, but you are broke (which, unfortunately, is often the case)?  Selling more, without changing something else in the formula, will not likely improve your situation significantly, but it can certainly be one part of the solution.

More than 25 years ago, I was part of a group that Steve LeFever invited to test his “Profit Mastery System” where, among other things, he introduced the concept of tweaking the above formula by including “required net profit” into your Operating Expenses.  We’ll talk about the other things in subsequent blog posts, but now let’s focus on net profit as an Operating Expense.

What motivated you to start your own business in the first place?  Probably a whole host of things, which may have included being your own boss, having independence, escaping the rat race, being in control, helping others, etc., but for sure you expected to create wealth and financial security for yourself.

If you are meeting all other expectations, but not meeting your personal financial needs/desires, then you are probably quite frustrated—however, you are definitely not alone in this situation!  In fact, it may well be the case with the majority of small business owners that they are not realizing the financial return on their investment into their businesses that they want/need/deserve.

Below are three examples to help you see the problem and the solution.

Example 1 indicates how you would normally calculate the break-even point for your business–again, break-even is where you are not making or losing money.

Example 1:

Sales                                                         $100,000        (100%)

Less: Cost of Sales                                   $60,000          (60%)

Gross Profit (Gross Margin)                   $40,000          (40%)

Less: Operating Expenses                      $40,000          


Net Profit                                               $0                    (0%)

Example 2 uses the same formula as Example 1 but includes “required net profit” in Operating Expenses.  “Required Net Profit” is the amount of money that you will need to have left over to pay your taxes, pay yourself, pay down loans, re-invest in the business, pay back investors, etc.  I use $50,000 in this example.

Example 2:

Sales                                                                                                             $100,000        (100%)

Less: Cost of Sales                                                                                       $60,000          (60%)

Gross Profit (Gross Margin)                                                                       $40,000          (40%)

Less: Operating Exp ($40,000 + “required net profit” of $50,000)       $90,000          


Net Profit                                                                                                   -$50,000          (-50%)

It appears that we are breaking even in Example 1, but when we add our required net profit into the Operating Expenses (Example 2), it becomes clear that in reality we are actually digging a financial grave for ourselves year after year, because there is not enough Gross Profit to satisfy our needs, pay our personal bills, and support the lifestyle that we want.

OK, so we now see clearly the problem (Point A), which enables us to look for the solution (Point B).

One obvious step to move us in the right direction is to increase Sales.  How much more would we need to sell in order to cover the $50,000 of required net profit?  It is a simple and easy calculation:

Operating Expenses ($90,000) divided by Gross Margin (40%) = Break Even Sales ($225,000) 

$90,000/40% = $225,000

Example 3 shows that you really need $225,000 in Sales, rather than $100,000, in order to break even.

Example 3:

Sales                                                                                                             $225,000        (100%)

Less: Cost of Sales                                                                                       $135,000        (60%)

Gross Profit (Gross Margin)                                                                       $90,000          (40%)

Less: Operating Exp ($40,000 + “required net profit” of $50,000)      $90,000          


Net Profit                                                                                                    $0                   (0%)

Now your business is breaking even.

Caution:  Just increasing Sales to improve your bottom line (Net Profit), has significant limitations, as you can see—we will also need to manage our Cost of Sales and Operating Expenses more effectively.  More on this in upcoming posts.

Where should you look when things aren’t going as well as you would like them to in your business?  From my experience I recommend that you go first to your financials.  This is where everything that you do in the name of your business is reconciled, and you need to know your financials inside out, upside down.  The good news is that you can do it.  It’s not a black box and it is not rocket science.  For the vast majority of small businesses, financials are pretty simple and straightforward, and, believe it or not, can actually be fun.

There are 5 financial tools that you will need to learn to use, so that you can analyze your financial information, assess the health of your business, and then make the decisions that will ensure the best possible scenarios for profitability and success.

I will discuss these tools individually in subsequent content with advice on what you can do to move your business into sustainable profits.  So I hope that you stay tuned!

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