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Here’s an example: Alex owns a custom framing store with low prices — just above cost — to attract customers. Volume helped keep the cash coming in. One wall of the shop was devoted to artist’s paintings, for which Alex received a percentage of the sale. Until a stationery store opened down the block, Alex was the only person in the area who offered custom framing. In addition to pens and printer paper, the stationery shop devoted a corner to custom framing at 20% less than what Alex charged. Alex quickly put a big sign in the window promoting the same price as the stationery shop — and finished the month in the red.
You probably recognize Alex’s mistake was changing his prices without assessing how it would affect profitability. It didn’t help that Alex didn’t know whether the framing shop was profitable to begin with.
Alex’s reactive pricing decision is one of many that a business finds itself needing to make every day. A contractor must decide on the number of workers to bring on board. A growing business may be offered a great deal on manufacturing equipment for cash today. In these cases, there may not be time to run the numbers to make a decision.
Related: Why This Metric Should Be Prioritized Over Growth for Startup Success
How is profit determined?
Your profit is the amount you have left after accounting for the cost of operating your business. It’s different from your revenue. Here it is expressed as a formula: total revenue – total expenses = profit.
Total revenue is all the money that comes into your business. For Alex’s business, it’s the money paid for framing plus the money received as a percentage of the paintings on the wall. If framing yielded $84,000 and the painting commissions yielded $24,000, Alex’s revenue for the year is $108,000.
Alex’s total expenses include the materials needed for framing, the shop’s rent, utilities and supplies. These add up to $96,000 for the year. Using the basic formula, $108,000 – $96,000 = $12,000 profit.
That’s not much wiggle room. A 20% drop in framing revenue means an annual revenue of $67,200; with the painting commissions, you’re looking at $91,200. If expenses don’t change, Alex’s framing shop is now unprofitable to the tune of $4,800.
What does knowing your profitability let you do?
Before the new competition showed up, all Alex knew was that the framing business paid its bills with a little left over. When the market changed, Alex needed to determine how to react.
Knowing exactly where the shop stood might have changed Alex’s decision. He might have chosen to reduce prices by only 10% — or not at all — or he may have looked for a way to reduce expenses, like finding a less expensive space to rent.
Knowing the profitability of any business enables the owner to react quickly. That can be the difference between profit and loss, as in the case above, or it can add profit. For instance, knowing that there was a $1,000 profit every month might have prompted Alex to rent a stall at a farmer’s market for $100 a month, which could have led to $500 worth of extra business, or he could have put more paintings in the shop for sale.
Business circumstances change and gainful opportunities present themselves at any time. Not every decision needs to be made in a split-second. However, if you can make one quickly, it can make or break your business. This can also be important if you’ve taken a loan out for your business. If your profitability is different than what you’d presented to your bank, it might affect the loan terms or interest rate. If your profit is less than expected because of the cost of needed materials, you can find a new vendor.
Related: Don’t File and Forget: Use Your Receipts to Gain Insight on Business Spending
How do you know whether you’re profitable?
To get a full picture of your condition, consider using the following tools:
- Profit and loss statement (or income statement). The basic math for this was covered above, but there can be a large number of elements that go into your profit and loss statement. If you know these now, you can make a decision now.
- Cash flow statement. A cash flow statement focuses on liquidity. In the example of Alex’s framing shop, suppose the commission on paintings was paid only once per year. Alex would be in the red most of the year. The essential formula is:
- Cash inflow – cash outflow = net cash flow. Cash inflow is any source of incoming cash; sales is the big one. Cash outflow is any source of outgoing cash such as rent, utilities, and taxes.
- Revenue vs. expenses analysis. Total your revenues and your expenses over a period (say, this month) and compare those to another period (for instance, the previous month or a year ago). You’ll see whether your business is making progress and what effect expenses are having on your revenue.
Real-time metrics for business health
The only way to know whether your business is profitable at any moment is to keep on top of your bookkeeping. Alex wanted to frame art, but soon learned that keeping books was necessary. The old-school way to do this was by recording each transaction in a journal. A more modern way is a spreadsheet. Cloud-based storage can help, and there are storage options from all of the major digital players. The most modern way to track your business is a document management system (DMS), which can capture data in multiple ways and store it in the cloud for access from multiple places.
Timeliness and accuracy are key. Decide when you will attend to your bookkeeping and don’t deviate from your schedule. Be accurate; double-check your entries and your calculations (especially with a spreadsheet). You’ll be glad you did when you’re making a key decision. If you think you’ll need data in an instant, then do your bookkeeping frequently.
Related: Want Taxes to Be Easy? Work on Them Year Round, Not Last Minute.
Now is your time
Banks can call loans, business can fall off, competitors can open, consumer demands may change, the perfect storefront may become available, a complementary business may be offered for sale at a great price — any of these may happen to your business at any time. Knowing that your business is profitable enough to react appropriately is the path to success. Do it. Now.
This story originally appeared on Entrepreneur
