Download HOW MUCH PROFIT IS ENOUGH Part Two

THE KEY TO YOUR SUCCESS –
HOW MUCH PROFIT IS ENOUGH?
(PART TWO)
“Keys to Your Success” is presented to improve your business, build your profit and grow your
sales. This article defines Profitability and how an investor measures your sustainability. Part
One described the difference between earning a profit and corporate profitability. Part Two
defines the measurement process.
The first part of this article stated that profitability is the amount that a potential investor would
need to buy or merge with your company. Now it’s time to measure your profitability.
So, how do you measure profitability? Some owners look at the income statement to see if the
results are positive. Some analysts look at the Balance Sheet to see if assets are higher. Some
executives review market share to see if you’re growing. The author believes that Profitability is
measured through a combination of three values.
1. Owner’s Compensation
2. Owner’s Return on Equity
3. Owner’s Reward for Business Risk
Owner’s Compensation
Compensation is the amount you earn from “working in your business.” Specifically, how much
would you pay to hire someone who could step into your shoes to perform your daily operational
tasks.
In contrast, “working on your business” includes non-recurring tasks, such as negotiating a bank
loan, finding a new warehouse location, deciding to upgrade all of your computer systems, etc.
Payment for providing these strategic tasks is excluded from your compensation estimate.
So, the first measure of profitability is how much profit do you allocate to your compensation?
If you are an absentee owner, then this amount is zero. The key question is: “How much would
an investor expect to spend to replace your operational skills?”
Return on Equity
The second measure of profitability is your Return on Equity. Invest $10,000 in a bank
Certificate of Deposit and you’ll earn a modest interest amount that is guaranteed. No risk, so
little reward. However, if you invest the same amount in your business, you can earn much
more interest in the form of profit. Your earnings potential is limited by your ability to lead the
company. So, your return on equity covers the market investment risk of your business.
We know that your risk is higher than the risk-free bank CD rate. It’s probably higher than the
current S & P 500 rate of return (because the S&P 500 is diversified to reduce risk). Keep in
mind that once you set the rate, it probably will not change regardless of the size of your
company. So, a 15% rate of return on $100,000 of owner’s investment is $15,000. When your
company grows and accumulates $500,000 of owner’s equity, then your profits must be more
than $65,000 (15% X $500,000 = $65,000) to meet this criteria level.
The goal is to ensure that your profits are high enough to cover your compensation (market
salary of your work), plus a return on your investment (interest rate times your owner’s equity before current year profits). But wait…the work doesn’t stop here. There’s is still one more
measure of profitability.
Reward for Business Risk
The third measure of profitability is the rate of return on sales that’s required to reward you for
your business risk. Every day, you incur a risk that your business can fail due to factors beyond
your control. If your business fails, you must pay your debts (without the benefit of recurring
sales income) and you’ll cease to have a personal income from your business.
Your company can fail for many reasons (i.e., fire damage, competitor price wars, product
liability suit, etc.) Every day you face a business risk that: a) your income stream can be
eliminated, and 2) you may have to cover debt repayment from your personal assets. Therefore,
you should receive a reward from your business to cover your risk. This is the third component
of profitability and is measured as a rate of return on sales. For example, if you determine that
an investor needs a 10% reward for business risk, you would multiply your annual gross sales by
10%.
That means that your profit must be high enough to cover three measures of success:
1. Compensation, or market labor rate for your work, plus
2. Return on Equity, or the interest needed each year from your owner’s equity (before
current profits are added to equity), plus
3. Reward for business risk which is a percentage of gross sales.
Once you achieve profitability, you’ll see new opportunities to grow your business. The reason
for this exposure is that you’ll discover that potential buyers will want to purchase your
company, vendors will want to be your favorite suppliers (because you can pay your bills), and
banks will be more willing to lend you money for business expansion.
If you are profitable today, then congratulations on your success. If you are not profitable, then
today is a good day to develop a strategic plan to achieve this level of success. When you are
profitable, when you operate with integrity, and when you’re clear about your corporate values,
customers will be attracted to you because they’ll perceive you as a leader in the marketplace.
This type of customer loyalty is invaluable to your long-term success.
869 words
Richard Melancon CPA, author of Integrity-based Leadership, has helped companies to grow
and improve profit in any economy for over 25 years,. Own a business? Want to own a
business? Ready to make meaningful contributions to your current organization? Richard works
directly with your company or he can address your next conference with impactful insight and
vision. Phone: (504) 780-909, E-mail: [email protected] Website: www.ramcpa.com.