How Much Profit Is Enough?
This is the fifth 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.
Determining how much profit is enough is a great question for every business owner to ask before the start of a new year. That is a much better approach than waiting for a surprise at the end of the year, which could be good or BAD. Since you are one of the few business owners that is asking this type of question, I have arranged five approaches to help you answer this question for your business.
Out of these five you should be able to find one or two that will work great for you:
- Being comparable with your industry is a good method, this can be determined through a benchmarking program from sources like Micro-bilt. If everyone in your industry is averaging 7%, you should be at or above the 7% target.
- ROI method – you should be getting 25% – 30% ROI on your capital in the business. If you have $500k equity in the business, the profit at year end should be $150k or more before tax.
- Debt service coverage – most lenders like to see 1.2:1 debt service coverage. That means EBIDTA needs to be 120% of the principal and interest payments on term and short term debt. If total P&I payment are $250k for the year, EBIDTA needs to be $300k. Profit is typically the biggest portion of EBIDTA
- Historic trends – if nothing else, you can see how your business has operated in the past and does that provide for enough profit to feel comfortable and do the things you can do in your business. If your company is generating 5% net profit historically, then it should continue to operate that way in the future.
- Your goals method – this one isn’t scientific but still works. If you have a goal to be debt free, then looking at your balance sheet and making a goal of paying off all debt in 3 years, then take your long term debt plus other short term borrowings and divide that by 3 and that will tell you how much profit you need to make per year to be debt free. If you have a goal to sell your business in 3 years, your revenue and profit should be trending up. Where does profit need to be to accelerate EBIDTA to get the money you want from your business? Or if it is to keep your bankers happy, what profit do you need to get your balance sheet in shape?
Overall, the most important profit goal is to have one. There is a greater probability of hitting a goal if you have one established and measure toward it each month. Without a goal, you are lost. Without measuring monthly you are lost again.
Have a great week and be profitable.
Business Growth Coach