Why isn’t my business as profitable as my competitors? Article #5 in a series exploring the big questions that entrepreneurs ask as they’re starting up and growing their businesses.
So you think your competitors have a leg up on you, eh? Let’s explore the challenge of profitability, one of the three obstacles that we created Business Breakthrough Networks to overcome.
What is Profitability?
Let’s start with the basics, because perhaps surprisingly, profitability has a few different definitions. If you read income statements like a pro, you can skip to the next section.
- Revenue. This is the gross income that a business makes from its normal business activities, usually from the sale of goods and services to customers. Revenue is also referred to as gross sales or, especially overseas, turnover. In personal finance, your gross income is the same as your salary. It’s called the “top line” because it’s literally the top line of an income statement. As Investopedia reminds us: “Revenue only indicates how effective a company is at generating sales and revenue and does not take into consideration operating efficiencies which could have a dramatic impact on the bottom line.”
- Income. Income and revenue are not the same thing, because “income” typically refers to net income, not gross income. Net income is the same thing as net profit, which we’ll get to in a moment. Net income is also called net earnings and sometimes just earnings. In personal finance, your net income is your “takehome pay” after taxes, withholdings, etc. It’s called the “bottom line” because it’s literally the bottom line of a corporate income statement.
- Profit. Profit is a very nebulous term. In reality, there are (at least) three types of profit. According to Investopedia:
- Gross profit, which is used to calculate gross profit margin, is a measure that analyzes a company’s cost of sales efficiency. The costs of sales figures include only direct expenses involved in generating a company’s products. The higher the gross profit and gross profit margin, the more efficiently a company is creating the core products that build its business.
- Operating profit is an analysis of a company’s indirect costs. Operating profit is in the second section of a corporate income statement. The operating profit is calculated by subtracting all of a company’s indirect costs from the gross profit. An analyst can see what types of endeavors a company is taking on to help grow the business from the indirect costs. For example, indirect costs associated with operating profit margin may include marketing campaign expenses, general and administrative costs, and depreciation and amortization.
- Net profit is calculated from the final section of an income statement. It is the result of operating profit minus interest and taxes, with interest and taxes being the last two factors to influence a company’s total earnings.
- Margins. Finally, profit margins are expressions of profit as a ratio. Profit gets measured in dollars and cents, while the profit margin gets measured as a percentage. According to Camino Financial, there are two types of profit margins:
- Net profit margin measures how much profit your business generated as a percentage of your total revenue. This is the more common way in which profits are described, but not the only way, which can lead to confusion.
- Gross profit margin, on the other hand, measures the income left over after accounting for the Cost of Goods Sold (COGS). COGS refers to the expenses directly associated with product creation. Gross profit margin excludes overhead expenses like rent or utilities.
Now for the good stuff. How do you compare your profitability with other companies? Just what is a good profit margin?
The answer is: it depends. Net profits vary pretty dramatically across industries. In general, net profits average around 10% for U.S. businesses. 20% is good, and 5% is typically low. This chart identifies some of the most profitable industries, and where they come in at for average net profits, according to Forbes in 2015.
Camino Financial has additional data on both net and gross profit margins:
Income statements can be misleading. For example, CFI writes that “investors and analysts view net income as a somewhat deceiving profitability measure that provides a distorted picture of the company’s operating efficiency.”
Investopedia notes that when comparing profitability across companies and industries, EBITDA (earnings before interest, taxes, depreciation, and amortization) may be a better choice. EBITDA “is used as a proxy for the earning potential of a business.” They write: “Investors and analysts can use gross profits to determine how well a company generates profit from their direct labor and direct materials, whereas they can use EBITDA to analyze and compare profitability among companies and industries.”
We hope this provides some additional clarity on how to compare profitability.
How does your profitability stand up against the industry standards and competition? Let us know in the comments below.