How to Add More Value Into Your Business – The Two Numbers You Need to KnowMay 13, 2022
Are you as profitable as you think? If you're not, it may be time to create more value, which might not be as hard as you believe.
By now, every business owner knows the importance of financial information, at least to some degree.
You need to know your numbers because they don't lie. And financial data can paint a pretty good picture of your company's performance.
But can you use this information to determine the value of your organization?
Even better, can you use it to add more value and make your business more attractive to potential investors and buyers?
Yes, you can.
That said, there are two financial metrics that directly impact your company's value – the gross profit margin and net operating income.
Getting a handle on these figures will help you make more efficient financial decisions in your business. That’s why this article will help you understand those two figures.
Gross Profit Margin
Let's look at two examples to really understand how to calculate your gross profit margin and why it's such an important number in your business.
Imagine you're selling a product for $2,000. To deliver that product to the consumer, you have to spend $1,600 in variable costs. This would give you a profit of $400 or a profit margin of 20%.
In another example, you're selling the same product for $2,000 but with a 30% profit margin. That means for every $2,000 item, you only pay $1,400 in direct costs incurred to fulfil the delivery. The additional 10% bump in your profit margin increases your gross profit to $600.
But here's the interesting thing here:
Going from a 20% to a 30% gross profit margin essentially means your margin goes up by 50%. It's a much more significant increase when you think about it.
Now, these numbers might not be super impressive. But let's look at the impact of gross profit margins when selling multiple units.
Imagine selling 50 units of your product. Your sales would total $200,000, and variable costs would amount to $80,000. That means that a 20% profit margin would only make you $20,000.
So now, let’s say your profit margin is higher at 30%. That means for every $200,000 made, you only pay $70,000 in expenses, thus raking in $30,000. And this is another example of how a 10% rise in your gross profit margins can actually mean making 50% more money.
Knowing your gross profit margins for all products and services is key to making good business decisions.
Keeping track of your numbers will help you optimize your pricing strategy and manage expenses better. That way, you can earn even more money while maintaining the same sales volume.
Of course, there's no magic percentage to shoot for. Every industry is different, and gross profit margins can fluctuate a lot between them.
But typically, a business should be able to maintain their gross profits between 15% to 35% of their revenue. Going past the 35% threshold means you're running a high-performance company.
Is Your Business Operating at a Loss?
Almost every company has both fixed and variable costs.
But what’s the difference?
Fixed costs never change depending on your sales volume. Meanwhile, variable costs are directly related to your product or service delivery.
To get more clarity, let's look again at the previous example. You're selling one product for $2,000 and making $400 in gross profit. If you were to sell two, you'd make $800, and so on.
This is where fixed expenses come in.
Say your fixed expenses were $800. You'd essentially need to make two sales to break even. Three sales upwards, and you start making a profit.
With that in mind, you need to ask yourself two crucial questions if you're operating at a loss.
- How can I reduce my variable costs to increase the gross profit margin?
- How can I increase my sales volume to cover the fixed expenses and make money?
To answer these questions, you'll have to learn how to calculate your operating income.
Knowing Your Operating Income
The operating income is the net income before tax and depreciation. Think of it as your company's true income before accountants get involved and the government takes a slice of the pie.
Calculating the operating income is very easy if you keep a good record of your financials.
Here’s how you do it:
Subtract the variable costs and direct costs from your revenue to get your gross profit. After you cover your fixed expenses, you'll get your operating income.
But why is this figure so important?
First, it allows you to understand how your company is doing. Therefore, you have a starting point to ensure the operating income will increase going forward.
Second, one of the most exciting aspects of this metric is appreciation.
You can use your net operating income to determine how much your company could be worth in the event of an exit.
The way this usually works is that businesses are valued at four to six times the earnings multiple. So, say you knew your company had an operating income of $100,000. You could be looking at a realistic exit of $500,000 on average.
Of course, if you have your sights set on a seven-figure exit, then you'll know what you have to do. You have to improve your gross profit margin, increase the sales volume, and manage your costs to increase your net operating income.
It's one of the primary drivers of value inside a business. The higher it is, the more profitable the exit.
Always Track and Manage Your Numbers
What do financial metrics really tell you?
They present summaries of how your business is or has been performing any given month, quarter, or year.
Although historical performance is essential, nothing is more vital than knowing your company's present value. Where you are will determine where you could be and how you'll get there.
Looking at your numbers should become second nature if you want to grow a valuable and sustainable business. Perhaps one that you can sell for a nice profit.
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