Profitability Equals Sustainability (Part 2)

Last time, we presented the concept of profitability as a measure of sustainability.  So, how do you calculate the amount of profit needed to achieve sustainability?  Keep in mind that in order for a company to be sustainable, annual profit must be enough to cover the three measuring points:  Owner’s Compensation, Return on Investment, and Reward for Business Risk.

 

Compensation:  What would you pay someone to perform the daily operational tasks that you perform?  Operational tasks are:

  • Functions that you should be delegating because they are recurring,
  • Activities that are necessary to sell and/or deliver product, collect cash, pay workers, etc.
  • Assignments that much larger organizations assign to Managers or Supervisors, or
  • Actions that keep your business on track (as opposed to actions that create change)

Return on Investment

This is calculated by taking your total equity, subtracting the current net profit for the period, and multiplying that resulting amount by a percentage rate.  The percentage rate is your estimate of what a potential investor would use to justify purchasing your company.

Reward for Business Risk

This is calculated by taking your total sales for the period and multiplying that amount by a percentage rate.

This is actually the most difficult calculation, because the better you design your company to be safe or to mitigate risks, the smaller the percentage rate that you will use.  So, a chemical refinery may use a higher percentage rate than an accounting firm.  The percentage rate is your estimate of what a potential investor would use to justify purchasing your company in your industry.

The difficulty is calculating the sustainability rate is that your growth does not impact the percentage rate over time.  So, 15% of $500,000 is $75,000 and 15% of $5 million is $750,000, but both amounts represent a 15% reward for business risk.  If you do not improve your safety as you grow, you cannot justify a smaller reward rate just because the number is larger at higher sales levels.  As a result, sustainability becomes more difficult at higher sales levels unless you manage your resources more effectively.

How do you determine profitability in your company?

Profitability Equals Sustainability (Part 1)

If your company made only one dollar in net income last year, many would say that your company had a profit.  The ugly truth is that your company must earn more than minimal profit in order to stay in business for one more year.

Being profitable means that you earn

more than the minimal level of profit each year

Profitability is equal to Sustainability because companies that are profitable qualify for bank loans, can negotiate better inventory costs from suppliers, and attract investors or partners (so you can retire with dignity and an income).

So what is the minimal level of profit for your company?  That is the hard question that YOU must answer, because no consultant can know the right answer for you.  Anyone who tells you the answer is, at best, projecting the “right” answer for himself/herself.

Your minimal profit consists of three parts:

  1. Reasonable compensation for your work in the business.  (What would you pay someone else to do what you do every day?)  If your role is pure leadership with no operational duties, you do not require compensation because you will earn greater profit.
  2. Return on Equity for the money you invested in the business (After all, you could invest in a bank certificate of deposit and earn interest without any effort, skill or stress.)
  3. Reward for Business Risk you take every day (i.e., risk of lawsuits, risk of customer non-payment, risk of chemical spills that disrupt your operations, etc.).

So, if you want to know the “right” answer, then ask a potential investor what he/she would need in each category in order to justify buying your business.  Remember, your business is worth what someone is willing to pay for it in a fully negotiated agreement.

What is your measure of Profitability?  Share your ideas and let is all build a better economy. Check back next week to learn the author’s method to calculate Profitability.