Many business owners mostly watch their sales and their bank balance. Those two numbers aren't enough. Rising sales can hide a shrinking margin, and a well-stocked bank account says nothing about your profits. Here is what to look at, how to calculate it and what to conclude.
What does it mean to be profitable?
Your profit is what's left of your sales once all your expenses are paid, including interest and income taxes. Your profitability is that profit compared with what it took to earn it, most often your sales. A profit figure on its own says very little.
Fictional example. Two businesses each make a $30,000 profit.
- The first has $150,000 in sales: it keeps 20 cents on every dollar sold.
- The second has $1,500,000 in sales: it keeps 2 cents on every dollar sold.
- If all their expenses rise by 3%, the first still makes a $26,400 profit. The second loses $14,100.
Same profit, opposite situations. That's why profit is always compared with sales. Count your sales excluding sales taxes: the GST and QST you charge don't belong to you.
Do your prices cover what your contracts cost you?
That's the gross margin question. Gross margin is what's left of your sales after your direct costs. Your direct costs are the ones you have to incur to produce what you sell. They include raw materials and production labour, but not marketing, sales or distribution. In a service business, they are mainly the time of the people who do the work, subcontracting and the supplies used for each contract.
The calculation: gross margin percentage = (sales − direct costs) ÷ sales.
Fictional example. A residential renovation business compares its last two years. The amounts illustrate the method; they are not a benchmark for the industry.
Fictional amounts | Year 1 | Year 2 |
|---|---|---|
Sales, excluding taxes | $800,000 | $1,000,000 |
Direct job costs (materials, subcontracting, labour) | $520,000 | $690,000 |
Gross margin | $280,000 | $310,000 |
Gross margin percentage | 35% | 31% |
Other expenses (overhead, interest, income taxes) | $240,000 | $272,000 |
Net profit | $40,000 | $38,000 |
Net margin | 5.0% | 3.8% |
Sales rose by 25%. Profit, however, fell by $2,000. The gross margin shows where the money went: it dropped from 35% to 31%. At the Year 1 percentage, the business would have kept $350,000 on its Year 2 jobs, or $40,000 more. Those four percentage points explain why the growth never reached the bottom line.
A falling gross margin almost always points to one of these causes: discounts, poorly estimated contracts, more expensive suppliers or unbilled time.
What do you have left once everything is paid?
That's your net margin. It compares your net profit, meaning what's left after all your expenses, including interest and income taxes, with your sales. It is one of the four ratios used to assess a business and is usually calculated after taxes.
The calculation: net margin = net profit ÷ sales.
In the example, the net margin drops from 5.0% to 3.8%. On every $100 of sales, $5 was left in the first year, and $3.80 in the second.
Two tips for reading it:
- Calculate it over the last 12 months, not over a single month. That smooths out the seasons and large one-time expenses, such as an insurance premium paid all at once.
- Read it alongside your gross margin. If your gross margin holds but your net margin slips, look at your overhead or your borrowing costs: they are growing faster than your business.
You may also hear about return on assets and return on equity: they compare profit with what the business owns and with the money its owners have put into it. They are calculated once a year, from the balance sheet, the document that lists what the business owns and what it owes.
Which services or clients really make you money?
An average margin can hide big differences. Some services carry your business; others hold it back without you noticing.
Fictional example, continued. The renovation business breaks down its Year 2 by type of work.
Type of work | Sales | Direct costs | Gross margin | Percentage |
|---|---|---|---|---|
Kitchens | $500,000 | $310,000 | $190,000 | 38% |
Bathrooms | $350,000 | $245,000 | $105,000 | 30% |
Small jobs | $150,000 | $135,000 | $15,000 | 10% |
Total | $1,000,000 | $690,000 | $310,000 | 31% |
Small jobs make up 15% of sales, but less than 5% of the gross margin. And this table doesn't yet count the time spent preparing quotes, scheduling and travelling. Once that time is counted, they could even lose money. The business can then raise its prices for this type of work, set a minimum amount per contract or stop offering it. The number doesn't make the decision, but it shows the choice to be made.
The same logic applies to each client. A client who asks for a lot of changes, or who pays late, can cost more than they bring in.
To do this breakdown, you need to allocate time and expenses among your activities, and write down how you do it. That is the whole job of a cost and profitability analysis by service.
How much do you need to sell to avoid losing money?
That's your break-even point: the sales you need to cover all your expenses. The break-even date is the day in the year when you reach it.
To calculate it, separate your fixed expenses, which you pay even when you sell nothing (rent, insurance, fixed salaries), from your variable costs, which follow your sales. The calculation: break-even point = fixed expenses ÷ share of each sale left after variable costs.
Fictional example. A service business has $9,000 in fixed expenses per month. On every dollar sold, it keeps 45 cents after its variable costs. Its monthly break-even point: $9,000 ÷ 45% = $20,000 in sales. If it sells $25,000 a month, it has a $5,000 cushion before it starts losing money.
The full calculation, the break-even date in days and the traps to avoid are in our guide to calculating your break-even point, step by step.
Why can a profitable business run short of cash?
Profitability and cash are two different ways of reading your business. Profitability shows up in your financial statements: a sale counts as soon as it is invoiced, an expense as soon as it is incurred. Cash shows up in your bank account. Cash flow is the money coming into and going out of the business over a period. Even a profitable business can have periods when more money goes out than comes in.
What happens | On your profit | In your bank account |
|---|---|---|
You invoice a client who will pay in 60 days | The sale counts right away | The money arrives 60 days later |
You pay cash for $30,000 of equipment | The expense is spread over several years | The $30,000 goes out the same day |
You repay the principal on a loan | No effect: only the interest is an expense | The money goes out |
You collect GST and QST | No effect: it isn't your revenue | The money is there, but you have to remit it |
You pay yourself a draw or a dividend | No effect | The money goes out |
Profitability tells you whether the way you do business works. Cash tells you whether you'll be able to pay your bills next month. A fast-growing business is often in this situation: it is profitable, but its money is tied up in unpaid client invoices and purchases made in advance. To keep an eye on this second side, see how to read and track your cash flow.
What to do
Review your ratios, ideally every month, so you can see changes coming. Here is a simple routine.
- Keep your books up to date every month. Sales and purchases recorded, bank balances reconciled with your statements, direct costs classified in the right place. Without that, your margins may be wrong. Monthly bookkeeping gives you these starting numbers.
- Every month, write down five numbers in a single table:
Number | Question to ask yourself |
|---|---|
Sales for the month and year to date | Am I on budget? |
Gross margin percentage | Do my prices cover my direct costs? |
Net margin over the last 12 months | What do I keep from each dollar sold? |
Gap between my sales and my monthly break-even point | How far can sales drop before I lose money? |
Bank balance and amounts my clients owe me | Will I be able to pay next month's bills? |
- Compare with the same month last year and with your budget, rather than with an average found online.
- Once or twice a year, calculate the margin of each service or of your main clients.
- Recalculate your break-even point when something changes for good: a lease, a hire, a price increase, a new supplier.
Frequently asked questions
What net margin should a small business aim for?
There is no single right number. Margins vary a lot from one industry to another. First compare your margin with your previous years and with your budget. Only then, if you have reliable data, compare it with businesses of similar size in your industry. A stable margin that you can explain is worth more than an impressive percentage achieved in a single year.
Should you include your own salary in the calculation?
Yes, especially when comparing. If you have a corporation, the salary it pays you is an expense, but dividends are not: two identical businesses can therefore show different margins depending on that choice. If you're self-employed without a corporation, your profit includes your pay. Subtract a normal salary for your work: you'll see what the business really earns, beyond your pay.
Your business loses money in some months: is that serious?
Not necessarily. Many businesses have slow months, because of the seasons, for example. Look instead at your profit over the last 12 months and its trend. Also make sure your cash covers the weaker months. If the 12-month total turns negative, or keeps falling month after month, look for the cause: gross margin, fixed expenses or sales.
How can you make your business more profitable?
First find where the gap is: a gross margin that's too low, fixed expenses that are too heavy or sales that fall short. Each cause has its own fix. You can rethink the price of services that pay poorly, renegotiate with a supplier, cut fixed expenses that don't pull their weight or grow your most profitable activities. Start with the costliest problem, not the most visible one.
Keep reading
Are your sales growing without your profit keeping up? Want to know which services really drive your margin? Alta Conseils works out with you what your services or projects cost and analyzes their profitability, one by one, to inform your prices and priorities. With financial projections, you can then measure the effect of a price increase or a new hire on the months ahead.
