- Understanding the different types of profit can make a huge difference to the way you start and manage your business.
- The first thing people think about in relation to profit is operating costs, but the cost of entry and developing a well-planned exit strategy and equally important.
- In this blog, we'll look at the three types of profit to understand as a small business owner and give you some tips to better manage your financials.
Most SME operators tend to think that good management, innovation, hard work and productivity will result in a profitable business, well they should but that’s not the whole story.
Not all profits are created equal, and indeed, some are much more valuable and more quickly and easily attained than others.
What Are the 3 Types of Profit?
Understanding the three types of profits will make a significant difference to the way in which you view and manage your business finances.
The three types of profit to understand as a small business owner are:
- Cost of entry
- Operating profit
- Exit strategy profit
1. Cost of Entry
The first profit for SMEs the easiest profit you will ever make and could account for a substantial amount of the total profit your business generates over its lifetime. The first profit flows directly from your cost of entry.
Once you decide on starting or buying a business be it a hardware shop, bakery, call centre, IT service or property development, do your research. Look around for a similar business in distress or even facing or in administration or receivership.
There are many reasons businesses fail but most often it's insufficient cash or poor management. If you are a good manager and you have the cash, get out there and buy well.
Most businesses fail within the first two to three years. I have bought near new businesses out of distress for less than 10% of the cost of establishing that business. Plant and equipment as new, some customers in place and ready to go.
If you can run that business and cash flow, you make a 900% profit in your first 2 years because a well-run business should be worth at least its true set up costs.
2. Operating Profit
This is the only profit some people think of; the operating profit that flows from good management, business planning, innovation, hard work, productivity and sales effort.
Operating profit most importantly sustains your cash flow, pays the bills, allows you to further develop the business and should leave you with a healthy profit after drawing your wages.
The real key to just how large operating profit is related to the lessons of the First and Third Profits. Put simply the keys to strong operating profits are how well you control the cost of the goods and services you offer and how well you price them.
Do the math. You are much better off and your business is stronger selling a lower number of products or services at a higher margin than going for volume at a discount.
Look for ways to offer a significantly better service to your customers than your competitors are and lift your prices.
Treat cost controls and buying as seriously as sales, manage your stocks to achieve maximum stock turn at minimum inventory. Establish and monitor your KPI’s. Motivate and reward your staff. Build a happy and united team.
3. Exit Strategy Profit
If planned carefully and executed well, your exit strategy will bring you a profit as relatively easy and large as your first profit. Whilst this seems a long way off when you start your business, you should be planning and working towards the exit every day.
The profit you gain from selling the business will directly reflect the desirability of your business to a potential buyer. That buyer will need to be very comfortable with your business if you are looking for a premium priced exit.
From day one work to a detailed financial budget and business plan, report against it monthly; draw up detailed monthly accounts, (it’s so easy today), hold monthly board meetings with an agenda and minutes, even if the directors are you and your wife. File all tax returns and corporate documents on time and constantly update your corporate register. Imagine how comforting 3, 5 or 10 years of such well-maintained records are to a potential buyer.
Lock as many customers as you can onto long term supply or service contracts and do the same with your key suppliers. Look after, reward and motivate your staff so that your retention rate will be high. Another three prospective purchaser concerns answered.
Typically a purchaser will offer a multiple of earnings (EBIT) plus stock at valuation as a pricing mechanism. If the accounts, customers and staff look ad hoc the multiple offered is going to be between 1 and 2 times earnings and stock over one year old will be discounted to $0.10 in the $1.00 and over six months old $0.50 in the dollar.
With solid accounting, tax and corporate records, good budgeting, a regular stock turn, sound supplier and customer relationships, and loyal staff a potential purchaser is going to look much more favourably on your business and a multiple of 4 to 6 times EBIT plus SAV at full cost is a likely outcome.
Another strategy is to approach your major competitor; consolidation of the two businesses could bring about significant efficiencies and cost benefits thereby lifting to value of your business to a multiple of 6 to 8 times EBIT.
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