Profitability Isn’t Real … Hear me out

“Am I profitable?” a client emailed me a few months ago asking this question. Seems like a quick question to answer if you understand a P&L- but … is it?

What does being profitable mean? What is profit? This is actually not a simple answer, and if you’re trying to answer this for your business, sip your coffee while I explain.

I had a finance professor say ALL the time - there is no such thing as “profit,” and after years of being a fractional CFO, I have to say that I agree (and maybe a little disagree because the world believes there is, so maybe he and I are both a little bit right and wrong).

In most cases, when people ask if they are profitable, they’re thinking about “net income.” Net income is the value of the Profit & Loss that subtracts all expenses and COGS from revenue.

NET INCOME = REVENUE - ALL COSTS

The tricky part here is that a lot of businesses do some fancy accounting to put things onto the balance sheet and not into Net Income. Your Net Income can look amazing, and you can still be bleeding money.

Where else do you look for profit?

After many of these conversations, I’ve learned that when most people ask, “Is my business profitable?” they’re really asking - “is my business healthy?” They want to know what they can expect, what they need to plan for,or how they can present their business in the best light to investors, bankers, and potential acquirers. (acquirers does not sound like a real word - is that just me?)

Is your business healthy?

Here are 2 quick questions that can help you get to a starting point, that doesn’t require any financial analysis (we’ll cover that in a sec):

1. Are you and your team compensated well? Put another way: are you and your team being paid a fair salary that allows you all to live the life you want and is comparable to what you would be paid doing the same work elsewhere?

2. Are you taking in more cash than you are spending each month (or choose a time period that fits your business’s seasonality)?

If you answered “yes” to BOTH of these questions - you’re likely doing pretty well. And if you answered no to one or both- it’s time to get some help.

Even if you did answer “Yes,” knowing exactly how profitable your business is is always a good idea. To do that, we need some financial analysis.

Here are 4 methods you can use to determine how profitable your business is. Below, I outlined when and who would want to use these.

EBITDA or Earnings Before Interest Tax Depreciation and Amortization

Free cash flows

Financial Ratios: the easiest ones: Debt to Assets and Current Ratio

CASH

EBITDA - Earnings Before Interest Tax Depreciation and Amortization, is a pretty popular metric looked at by investors. This number gives you what’s left of revenue BEFORE you account for interest, and taxes. It also does some fancy accounting with depreciation and amortization (if you don’t know what those are - then you’re probably not doing them, and you can skip it).

The downside to this number - as with net income - is that you can still be putting things like owner pay on the balance sheet vs in payroll on the P&L. This can make your EBITDA look high. I personally like owner pay to be on the P&L if you're a small business because you're doing the core work of the business. My general rule is: if you would hire someone to replace you - then your pay should be on the P&L.

Free Cash Flows - This is the favorite for acquirers. The Free Cash Flows method is as close to true profitability as possible. This calculator shows you how much cash is running through the business. It’s not terribly complicated, but I do find that the calculation can trip people up as it is a bit more involved than EBITDA. The main difference is you’re accounting for working capital and CAPEX, whereas EBITDA doesn’t mess with those numbers.

The simplest formula for this is:

EBIT* x (1 - Tax Rate)

Non-cash expenses (depreciation & amortization)

Change in (current assets - current liabilities)

Capital Expenditures (CAPEX)

= Free Cash Flows

*EBIT = earning before interest and taxes

Financial Ratios - These are SUPER handy and almost always overlooked for small businesses. There are A LOT of ratios that an analyst can pull out and review, but there are two main ones that can provide a decent amount of insight for a small to medium-size business with minimal effort:

Current Ratio. You can get this by dividing your current assets by your current liabilities. This shows you how many times over can you cover your current liabilities. Anything over 1.5 is very strong; anything under 1 is a red flag. The downside here is that far too many businesses need to clean up their balance sheets to get a clear picture from this metric.

Debt to Asset. The calculator for this is total debt / total assets. This shows you how much of your assets are being used to cover debt. A Debt to Asset ratio between 0.3 and 0.6 is typical and a good range if you're looking to sell or bring on investors. Lower is always good, and higher is a red flag.

And last and MOST important:

CASH. Cash is king; building cash reserves, paying people well, having a lot of cash = healthy business.

There’s no analysis here, just pay attention to your cash. Do you have more coming in than going out? Is your reserve account continuing to grow? Are you paying higher and higher dividends to investors and owners? Then you’re in good shape.

CASH DOESN’T LIE!

The hard truth of this: there is no “PROFIT” number on any of your financial statements. And there isn’t one magic number that tells you or the world of your success.

Understanding the health of your business is so much more about understanding your intent and the goal of the business. When your goal is to live a certain lifestyle and pay people well, then your metric for success and profitability becomes your pay, and the pay of your staff. For businesses planning to grow and scale quickly, your metrics will be different, and investors aren’t necessarily going to care what your current EBITDA is today, but what the potential is in the future. Always be matching your targets and metrics to your goals and don’t necessarily worry about a specific number on the P&L or Balance Sheet.

Business ebbs and flows, markets shift, customers change, it is unpredictable. You can be “profitable” one year and not the next. And it is not one number that will tell you if you’re on or off track, it is the entire picture and how those numbers work together that tells you if you’re “profitable” (aka running a healthy business).