How to Gain Insights into Your Business's Financial Health through Profitability Analysis
Is your business making as much profit as it could be? If you're not regularly analyzing your finances, you may miss critical insights that could help you improve your profitability. In this blog, we'll walk you through four steps to conducting a successful profitability analysis for your small business. By closely examining your margins, client valuation, past numbers, and industry benchmarks, you can better understand your business's financial health and make informed decisions for its future growth.
Step #1. Calculate Margins
It would help if you calculated your profit margins to understand how much money your business is making. There are two types of margins you should know: gross and net profit margins.
Gross profit margin is how much money you make after subtracting the cost of producing your product or service from your revenue. In simpler terms, it's the money you make before paying for other business expenses.
Net profit margin, on the other hand, takes into account all of your business expenses, such as salaries, rent, marketing and admin costs. To calculate it, you subtract all your expenses from your revenue to get your profit, then divide that number by your revenue.
It's also important to look at segment profits. If your business has different revenue streams from different products or services, you should calculate the profit margins for each segment. To do this, subtract the costs for each segment, including overhead expenses, from the revenue it generates.
By doing this, you'll better understand how much money your business is making and which segments are contributing the most to your profitability.
Step #2. Perform Client Valuation
To understand how much profit each of your clients is bringing in, it's important to perform a client valuation. This means determining the worth of each client by subtracting from the revenue (from that client) all of your costs, including marketing, hourly labour, and travel expenses (to deliver the service to that client).
When determining the costs of keeping each client satisfied, it's important to consider all the expenses you incur to maintain that client. For example, you may find that some clients aren't paying much for your services, but their projects take very little time from you or your team, which can lead to a better profit margin.
On the other hand, some clients may require a lot of time and resources, leading to a lower profit margin. Evaluating the worth of each client can help you decide which clients are worth keeping and which ones you might need to part ways with.
By identifying your most profitable clients, you can focus on retaining them while seeking new, similar clients. Additionally, analyzing your less profitable clients can help you identify areas where you may need to adjust your pricing or services to increase profitability.
Step #3. Look at the Past Numbers
Looking back at your past financial records can give you insights into your business's performance over time. A thorough profitability analysis should consider multiple quarters and even years to help you identify trends and patterns that can help you make better business decisions.
Why is it important to look at past numbers? Well, even if your current numbers seem positive, without looking at the bigger picture, you might miss opportunities to make more informed decisions. In addition, by analyzing your past records, you can better understand the factors that have contributed to your business's success or lack thereof and plan your future strategies accordingly.
If you need help figuring out where to start, consider hiring an accountant or financial professional to help you analyze your past records and gain valuable insights into your business's financial history.
Step #4. Benchmark Industry Ratios
Remember that your profitability numbers only mean something in the context of your industry. This is because different industries have different profit margins. For example, accounting firms typically have a higher profit margin than retail stores.
So, while it's important to look at your past and current profitability numbers to track your business's progress, it's just as important to benchmark your business against your competitors and the industry average.
Comparing your business to industry benchmarks can give you a better understanding of where your business stands in relation to others in your niche. In addition, it can help you identify areas where you're falling behind and need to improve and where you're excelling.
To get started with benchmarking, find out what the average profit margins are for your industry. You can find this information by researching online or talking to industry experts.
Once you have this information, compare it to your own profit margins. Are you above or below the average? If you're below the average, you may need to make some changes to your business model or operations to improve your profitability. If you're above the average, congratulations! Keep up the excellent work, and look for ways to stay ahead of the competition.
Do It for Peace of Mind and Direction
A good profitability analysis can help curb anxiety regarding your business. And at the same time, it can tell you what you should do to improve and grow it.
If you ever find your business lacking direction, remember that a profitability analysis can help you spot issues, you couldn't otherwise.
It's a game-changer!