This is the second article on “profitability”—a guide to help understand and develop the true significance of its impact on a business: revenue growth, peace of mind and freedom to do about whatever you want to do.
John owns a small manufacturing company that has been in the family for years. John’s dad did a great job at teaching his children the trade, but wasn’t as successful in helping John and his siblings understand the importance of profit. But lately John has received an accelerated education on the impact the lack of profit has had on his business. Here’s a summary of what John has learned:
- Losses eat away at equity to a point where lenders feel that the business is too risky to lend additional money to.
- Good employees leave because the company doesn’t have the money to keep the competition from stealing the good help.
- Equipment maintenance is reduced, shorting the life of the equipment.
- Officers are paid less because the company doesn’t have the cash.
- Bonuses and distributions are eliminated because there is no cash.
- Vendor terms shorten or go to COD because payments are not paid according to terms.
- Large projects are shunned because the company doesn’t have the ability to fund material or labor costs.
- The value of the business drops dramatically.
The above is just a partial list of what lack of profit does for a business. But what good does a profit do?
Here are 11 reasons why profit is essential to the longevity, growth and safety of the business:
- Essential for survival – Any entity cannot spend more money than it takes in. It just doesn’t work over time.
- Funds growth – As business revenue grows, key assets expand (accounts receivable, inventory, rolling stock), and to keep up with that asset growth either liabilities or equity (or both) also have to grow. Profit is the primary component that grows balance sheet equity. Growth in equity allows growth in lender/vendor debt.
- Ability to borrow money – Lenders won’t lend money to businesses that are not profitable. Lenders look to profit to pay back the borrowed money. No profit = no ability to pay back; therefore no new loan. Lenders also look at profitability as a way to measure the ability of management to run the company as follows:
- Businesses that are consistently profitable – Great management.
- Businesses that are profitable but erratically – OK management.
- Businesses that lose money – Poor management (run away as fast as possible).
- Grows market value of business – Profit is typically the biggest component of EBIDTA and businesses can obtain 2x-8x EBIDTA for valuation purposes. Profit is much more valuable than the assets of the company.
- Measures the effectiveness of management – Profit is one way outsiders measure the effectiveness of the management team. Lenders, investors, and vendors all use profit as a tool to measure how good management is in running their business.
- Ability to pay down debt – Profitability, if not used to grow assets, can pay down debt. Businesses without profit cannot pay down debt.
- Builds working capital – Profit is one of the elements that improves working capital. Businesses that are consistently profitable have consistent improvements in the ability to fund working capital needs, such as increased labor costs, big jobs, longer terms, etc.
- Attracts investors – Investors want to be on a winning team. People with money want to make more money with their money, not lose it. Profitability is the measurement of management’s ability to operate efficiently (this is defined as making profit) and investors will typically look at the historic profitability as a reflection of management’s ability to perform in the future.
- Hire better employees – Profitability is one of the few things that enable businesses to hire better people. Profit creates cash. Companies that are not profitable don’t have the cash resources to pay or increase the pay of good employees.
- Builds cash – Profit is one of the few things that will enable a company to increase cash in the bank.
- Enhances ability to give – Want to give to your favorite church or charity? You can if you are profitable, but you can’t if you’re not.
Have a good week and identify 3 ways you can improve profit this year.
Business Growth Coach