It is entirely possible to make sales without retaining any profits. It’s also possible to make profits without any cash to show for it. Sales have to be converted into revenues before they become profits. When you make a sale you provide a service or good to customers. Making a sale doesn’t guarantee that you generate revenues. It’s only when you invoice or bill the customer that revenue is recorded in your books. It’s quite common for businesses to provide services and then forget to bill. In some cases, the bill is full of errors. You can bill the wrong customer for the wrong services or wrong quantities at the wrong prices. These mistakes can eat away at your margins. Sometimes we forget to include taxes and yet the taxman never forgets that you cheated them. At some point, they will come for their sales taxes.
Each product or service we provide has a relevant production cost. The difference between revenues and costs of goods sold is the gross profit. The ratio of gross profit to revenues is the gross profit margin. The higher the gross profit margin the better for the business. You can improve your gross profit margin by increasing prices and/or reducing production costs.
When we deduct operational expenses from the gross profit we end up with an operating profit. The operating profit is sometimes referred to as EBITDA (Earnings Before Interest Tax Depreciation and Amortization). The ratio of operating profit to revenues is the operating profit margin. This ratio tells us to what extent the business has succeeded in controlling operating costs like payroll, rent, marketing, fuel, etc.
The net profit is finally derived by deducting interest, depreciation/amortization, and taxation costs from the operating profit. The net profit is what remains to be shared by shareholders and/or reinvested in the business for further growth. The proportion of net profits to revenues is the net profit margin. The higher the margin, the better for the business. A benchmark margin is at least 10% which is what you would earn from a simple unit trust.
The net profit does not automatically translate into cash in the bank. The revenue you billed has to be collected fully and on time. You then need to control costs and manage your working capital prudently. Similar businesses may have different profit figures. This will often occur because revenues and costs are usually recorded on an accrual basis and different businesses will adopt different accounting policies. A business usually prepares a cash flow statement that reconciles the opening and closing cash balances. If you have billed accurately and collected your cash and controlled costs; we should see an increase in cash balances. A consistently declining cash balance spells trouble for a business.
Your net profits eventually enter the balance sheet as retained earnings where they can be used to buy more business assets and or pay dividends. The balance sheet shows your assets and liabilities. If the business is profitable we expect to see the net assets increase and the reverse is true. Comparing net profits to net assets or equity yields a return on capital employed. You want this ratio to exceed the benchmark return of at least 18.5% which you would earn from a long-term treasury bond.
So don’t get so excited when someone tells you they are making a killing doing this and that. Politely ask them what their gross profit margin is. If they respond inquire about their operating profits. If they are still confident, ask about their net profit margin and return on capital employed. If they answer these questions affirmatively, then they know what they are doing. If not, they are just another excited person who is likely losing money but has no idea whatsoever.