The Entrepreneur Life

Tag: profitability

Do You Understand Revenues and Profits? A Primer

“So how did the meeting go?”

My friend was in the process of hiring a private banker to help find a buyer for his business.

“I thought it went really well. He liked what we’ve done so far and felt that there’s some interest in the market. However, he feels it’s really important to improve our EBITDA before we can get a good deal.”

I almost fell out of my chair hearing this. No, not because buyers would like a good EBITDA but that my friend actually said this. The previous two years – we’ve known each other for 20 years now and he’s been in business longer – I’d struggled to get him to clearly state what his gross margins were and what was preventing him from having consistent profitability.  My friend by no means is alone. Of course, younger entrepreneurs – many of whom come from technology backgrounds don’t have much exposure to matters of finance (or accounting). Yet having rudimentary financial literacy is critical for I’d argue all of us, entrepreneurs or not. But particularly for entrepreneurs, especially those NOT bootstrapping their businesses should understand the basic concepts and some key terms. As I’ve argued elsewhere, you should then be able to write out each of these, at any time, on a blank piece of paper – so that you have your important numbers at your fingertips. So here goes – with the warning, that these definitions are intended not for compliance to accounting as much to have a realistic image of where your business ACTUALLY is.

Of course, younger entrepreneurs – many of whom come from technology backgrounds don’t have much exposure to matters of finance (or accounting). Yet having rudimentary financial literacy is critical, I’d argue, for  all of us, entrepreneurs or not. Entrepreneurs, especially those NOT bootstrapping their businesses should understand the basic concepts and key terms. As I’ve argued elsewhere, you should then be able to write out each of these, at any time, on a blank piece of paper – so that you have your important numbers at your fingertips. So here goes – with the caveat, that these definitions are intended to provide you with a realistic image of where your business ACTUALLY is, rather than for compliance with accounting standards.

Revenue – this is the money customers pay you. The simplest case is when you sell a product (an app, a book or a sandwich) for $0.99, $1.99 or $4.99 that’s your revenue. If you sold 1000 apps a month, your revenue that month would be $990 (1000*0.99) and for 1000 sandwiches it would be $4990. (Let us not in case worry that when you sell sandwiches you seem to make more money. Conceivably you could send millions or even billions of copies of your app – a little harder to do with sandwiches (or not if you are in India :). This is commonly referred to Gross Revenues for clarity.

Net Revenue In the case of selling sandwiches (directly), the entire $4.99 comes into your pocket. However in the case of the app, only 70% of the $0.99 makes it to you (after the app store aka your distributor, takes its 30% off the top). So the reality is that those 1000 apps you sell make you $693 (70%*$0.99*1000). This is a significant difference to keep in mind – for when we plan with revenue in mind, and not gross revenue, that 30% difference (or $300 in this example) is likely to come and bite us in the ass. This is even more important, in the case of marketplaces or services, where your business is essentially acting as a distributor – in which case you get to keep the 30% (or 15% or worse yet 7%) of the revenue and pay your principal the 70% (or 85% or 93%) of the revenues. Given the recent “hot” status of food-delivery companies (can anyone explain what’s tech about these) or any of the e-commerce companies, it’s important to not confuse gross revenues (or GMV – gross merchandise value as they call it) with net revenues. Before we all switch to selling sandwiches, it is important to keep in mind, that software or e-books have practically no incremental costs whether you sell 100, 1000 or millions of units. However, for each sandwich, we incur the costs of those slices of bread (or wraps) and all that you put in between them. This is termed as the cost of goods. So in conventional businesses Gross Revenues – Cost of Goods (- Channel Costs too if they are non-zero) is termed Net Revenue.

Gross Margins (or profit) Gross Margins are essentially the difference between (Gross) Revenues and Net Revenue – often expressed as a percentage. This is a particularly critical measure as the profits of your business are constrained by this value. And yes Dorothy, profits are why you are in business. The higher your gross margins, the higher profit potential your business has. Often gross margins tend to operate in bands for specific industries or businesses and this is a good thing, for you to be able to measure where you are relative to others. In the above examples, for the app business, your gross  margins are 70% and in the case of the sandwich business, assuming the cost of goods for your fancy sandwich are $2.00, then your gross margin is 60%($4.999-$2.00)/($4.99). In these examples, if you sell your apps directly to users – on your website – your margins can increase to say 90% or use cheaper ingredients in your sandwiches (or leave out the cheese) you can increase margins. Such gross margin increases often translate directly to your bottom line. Again keep in mind, we make money in dollars and not in % dollars – so knowing both gross margins  in % terms and absolute dollars is important. Do you know what your gross margins are and how you can increase them?   Can you increase your gross margins to be so high that it can hurt your business? Yes, you can but that’s for another day.

Operating Expenses Simply put, all the expenses you incur, regardless of whether you make a dollar of revenue or not, are your operating expenses. And should you be lucky enough to make revenues, these are only likely to grow. So the cost of paying your engineers or employees, your rent and utilities, the cost of maintaining a website (and that fancy domain name you bought), advertising and trade show expenses are all operating expenses. In an ideal world, you’d try to keep your operating expenses low – but not so low that you are not able to ship product or deliver services that generate the revenue. And depending on the nature of your business, for instance, if you do drug discovery or build semiconductors, your operating expenses are likely to be high – even without R&D costs. Operating expenses too, like gross margins tend to operate in bands for specific industries, so you can benchmark yourself – allowing for where you are in the life cycle of your business (early, steady-state etc.). By nature operating expenses have some non-negotiables such as salary, rent, and utilities – you can decrease them only so much or not at all and others such as market or R&D expenses that are more amenable to adjusting.

Operating Margins This is your Net Revenue minus the Operating Expenses. This like the gross margin is a critical metric of the health of your business.    When businesses talk about reaching operating profit, they are essentially saying that their operating margins are higher than zero. In your app business, if you are spending $4000 a month and bringing in $4500 in net revenues (70%*$6500 in gross revenues) then you have achieved operating profit. Operating profit does not imply that your business is profitable (yet) but is capable of being so. For instance, in the example cited, this doesn’t take into account the 1 year and $50,000 you spent already to get to develop your product and this run rate.

This operating margin is what the some bean counters love EBITDA – Earnings (profits) before Interest (on your loans), Taxes (yep those exists and you may have to pay them if you actually make a profit) and Depreciation and Amortization (lets not even go there). It’s a somewhat independent measure the ability to your business to make profits.

Net Margins In plain English this determines whether your business actually makes a profit – money you can put in the bank, or pay dividends with or better yet flow back into your business. So even though you may make real operating profits, if the interest on capital you’ve borrowed for instance is high, you may not have any net margins. This is why the cost of money or borrowing costs can make or break businesses that have high amounts of debt. Similarly, if you have to pay taxes (and you do if you make profits) this can drive your net margins down. At the end of the day, this is the ONE metric that will keep you alive and fund your growth. However, maximizing this requires you to manage every one of the above – increasing gross revenues and gross margins allows more money to flow into the company. Decreasing or managing operating costs and financial costs ensures you maximize profit and can fund growth.

The table below summarizes the terms discussed for a variety of different businesses

Revenues & Margins

Can businesses run without making operating profit or positive EBIDTA? Did not Amazon do this for years and Flipkart and others doing this even as we read this? Sure – all that means is someone (investors, founders, in rare instance public markets) is pouring capital and investment into the business – usually with the reasoning that you are capturing market share or leadership and therefore spending more than you are making. They are also operating under the assumption, that one of these days you will make a profit and enough of it to justify the investment.

Meanwhile, for the rest of us 99%, knowing and keeping a good eye on these numbers would go a long way to ensuring you stay alive and thrive.

3 Steps to Achieve Profitable Growth

I never ceased to be amazed at how fast time seems to run right by us. Here we are in the second week of December and soon another year will be gone. Over the last four weeks as I’ve talked to a variety of entrepreneurs – it seems like they just got started and now already they’ve been in business for 4-5 years. Where did the time go, I find myself wondering. I’m not always sure that they wonder about it!

More importantly as some of them struggle for consistent growth and profitability, I find our conversations veering towards figuring out what’s working for them. In these conversations, I find myself repeatedly asking three or four questions

  • What is a typical deal size for you?
  • How long a selling cycle do you have – between first contact and first payment or purchase order
  • How many of these are repeat customers?
  • With which of these customers are you actually making money?

The funny thing is despite age or relative success of the business or experience of the entrepreneur this data is not that handy usually in most startups that I meet. It’s when they encounter a bump or worse yet a wall, they seek help and often the answers lie within such data. Of course sometimes it does not, but we’d know that only after we look at the data. Three things that are worth doing are

Analysis framework Build yourself a simple revenue and profit analysis framework – this could be simply a spreadsheet, like a sales tracker, but instead of forecast it shows what transpired. Ideally you would cover revenue, sales cycle, gross margin by account or customer (outside-in) and by-product or service offering (inside-out) and if you have a large enough team, even by salesperson. Depending on the nature of your business this could over a weekly, monthly, or quarterly period. Even if you review only on a half-yearly or annual basis, having the breakdown at least at a monthly level, helps.

Periodic reviews Any data and analysis is not of much use, unless you periodically review it. I’d include as many senior folks (if not your entire team) in such a review. The goal of the review is to really understand, which customers and products actually make profits for you – how long it took you to acquire them and why they’ve stayed with you or given you repeat orders. Alternately it will tell you if you are NOT getting repeat orders or those repeat orders are NOT coming fast enough or at better margins. Including the larger team, allows you to do find bottlenecks and assumptions within your own team – why proposals or demos take longer than they need to (selling cycle), costs are higher (team tries to get one customer to pay for entire dev cost etc.) Also it reminds the team that business is about making profits, not just shipping products (or proposals) alone.

Action plan Three critical actions can come out of such reviews

  • identifying what worked and doing more of this. Could include up selling to existing customers, culling non-profitable ones, tracking and shortening lead-to-customer conversion cycle times
  • designing experiments to validate things that are unclear – did that email campaign work, did pricing make a difference, what worked for one account or sales person can it be used for others – this helps find what worked (and what didn’t)
  • modifying your analysis framework do you continue to measure what you are presently measuring? What do you remove? What do you add, so that the analysis framework -> periodic review – > action plan cycle serves your purpose of profitable growth.

As December winds down and a new calendar and fiscal year loom, this might be a good time to look at this.

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