Hi, everyone. This is Nishi Patel from N-Accounting. I hope you having a great day. And in today’s video, I want to talk to you about why does profit matter and what are the different types? So the video I did before this one was called Why Does Gross Profit Matter? So this is a follow-up video to that because there’s other types of profit. I want to help you understand how they all work and how they relate to each other.
So the last video I explained that gross profit is probably the best indicator that you’re charging the right amount, that you’ll get from a profit and loss report. So that’s why it’s important to get that, be aware of what it is. But today, what I want to talk to you about is what we call net profit. So before, we spoke about how you have a sales figure, you take away cost of sales, so any costs that directly relate to those sales, you end up with a gross profit figure. Then today, what I want to talk to you about is how the gross profit figure turns into a net profit figure.
So in the last video, I also mentioned we’ve got overheads. Overheads are costs in your business that aren’t directly related to sale. I use the example of if you didn’t sell anything tomorrow, would you still have to pay the rent on your premises? Would you still have to pay for your accountancy fees? Would you still have to pay for your phone line rental? Yes, you would. So those are what we’d consider overheads, costs that are always going to be fixed. There are some overheads where they may seem a little bit more like cost of sales. We call them [inaudible 00:01:38] variable overheads, but for the purposes of this video, I won’t go into those. So we’ll talk about fixed overheads.
So what happens is when you’ve got your gross profit, you take away your overheads, you are left with something called your net profit. Your net profit is probably the best indicator of how much money your business is making. In my business and with our clients, I actually call this the annual salary equivalent because when we calculate net profit for the purposes of their own reports, we don’t include things like director salaries at that point. Although the pure sense of the term net profit would include a director salary. So this net profit or annual salary equivalent is the best indicator of how much money you’re actually making as a business.
And the reason that’s important is you might be working 50, 60 hours a week, right? You could be throwing everything you’ve got into this. But you owe it to yourself to ask the question, are you doing it right? And would you be better off just shutting everything down and going to Tesco’s and stacking shelves, or getting a job in an equivalent field where you get more money. And to really ask yourself, answer this question, you have to understand how much money you’re making.
Because if you’re making less than zero pounds an hour because you’re actually investing money into your business, and you’re not seeing any growth or any way forward, then yeah, the answer could be you have to give up your business. But before you do that, you should always look at fixing things first. But if it’s a case of you’re making money, it’s an amount of money you think is okay, you’ve still got to ask yourself, well, for the amount of work and effort I’m putting into it, how does it stack up against me getting a job or other things I could be doing?
So that’s why the net profit or the annual salary equivalent, as I call it, is really, really valuable. It helps if you understand if you’re making the right decisions, if your business is delivering what it should be, and whether or not you need to take action to turn things around. If you want to find out a bit more about this or anything else I’ve spoken to in these videos, then please get in touch. Book in a strategy session. I’d love to hear from you. And keep an eye out for the next video.
What Is Gross Profit and Why Does It Matter?
Hi, everyone. It’s Nishi Patel from N-Accounting. I hope your have a great day. And in today’s video, I want to talk to you about what is gross profit and why does it matter?
So a lot of you may have accounting software and when you go to that accounting software to categorize your expenses, you may notice that you have a few choices in terms of where to categorize those expenses to. And one of the most interesting things about those choices is they tend to be split into two groups. There’s a group called the direct costs. You may recognize it containing things like materials and subcontractor fees, and there’s a group contain your overheads. And you might recognize that as a group containing things like your rent, your accountancy fees, your advertising costs.
So when you categorize expenses in your accounting software, you’ve got a choice of which one of those groups to put it under. And a lot of people don’t really understand the relevance of those two groups. They’re just like, I’ll just pick the category that sounds about right, and stick it there, which is a reasonable assumption to make. But I wanted to help you understand what the point of those two groups are and how they relate to gross profit.
So the first group, the one we call direct costs, otherwise known as cost of sales, it contains things like expenses in your business that relate directly to the sale. The way to look at that type of expense is to ask the question, if I didn’t make this one sale to this customer, would I still have that expense? If the answer is, yes, it probably doesn’t belong in that group. It’s more of an overhead. For example, if you didn’t sell anything tomorrow, would you still have to pay the rent on your premises? Would you still have to pay your accountancy fee? The chances are yeah.
But the other side of it is, if you sold to of something tomorrow, would you have to pay for materials. The chances are yeah, you would have to pay for the materials. But if you didn’t sell anything tomorrow, you wouldn’t have to pay for the materials to make those things. So the thing is, the materials, anything that you have to use, it could be ingredients if you’re a chef, it could be bricks if you’re a construction company, anything that goes into the end product that’s directly linked to the number of that end product you sell should sit within cost of sales.
So the reason why that’s important is because that helps you work out your gross profit and your gross margin. So think about it this way. If you take your sales figure, let’s say you sold £1,000 of stuff, and the materials that went into making that £1,000 of stuff costed £500, you’ll be left with a gross profit of £500. So 1,000 minus 500 will leave you with a profit of 500. That’s in gross profit. You haven’t factored in your overheads yet.
So let’s talk about why the gross profit is important. Well, the gross profit is important because it’s possibly the biggest indicator that your pricing strategy and the amount you’re charging for your customers is effective. It’s also an indicator that the deals that you’re getting with your suppliers for those raw materials is healthy as well. But most importantly, the reason people really look at the gross profit is it gives an indicator of, is this business sustainable or not?
If you think about it, if you’ve made a loss at the gross profit stage, you sold something for £1,000, but it actually cost you £1,200 of materials and direct labor to produce, then you’re selling something for less than it is worth. So this is why understanding your gross profit is so important because it helps you understand if you’re actually making enough money at the very basic price level to start covering your overheads, but more importantly, to start contributing to your own lifestyle.
So what I’ll do is I’ll do another video just about overheads and why they’re important and how they feed into things like net profit. But in this video, the takeaway point I really want you to have is that firstly, get your accounting software in order. If you aren’t putting things in the right pace, or you don’t have the right categories set up, you’re never going to understand gross profit, which means you’re never going to understand if you’re actually charging enough. So if you want help with that or anything else I’ve discussed in these videos, get in touch, book yourself in for a strategy session and we’ll go through it. All right, thank you. Have a great day.
Cash Flow vs Profit: What’s the Difference and Which is More Important?
It’s the age-old debate: cash flow or profit? Whilst the two are undoubtedly related, they are certainly not the same thing and business owners must often sacrifice one at the expense of the other. In the long term, a business needs both positive cash flow and profits to continue operation, but which one should entrepreneurs be prioritising? Some say that “cash is king” whilst others argue that “profit is everything,” but what is the truth? Let’s take a closer look and find out.
What is Cash Flow?
Cash flow is the money flowing in and out of a business. It refers to available funds rather than money tied up in uncollected profits or hard assets. A business needs cash in order to continue operations; without it, the owner cannot pay suppliers, staff and utility bills, or purchase inventory. If your business is a car, then cash flow is the petrol in the tank – you can’t move forward without it.
There are three main types of cash flow:
- Operating cash flow: the amount of cash generated from regular business operations, such as sales.
- Investing cash flow: cash earned from investments, such as securities, property or the sale of assets. During a period when your business is actively investing, this number may be in the negative but it will become positive when these investments begin to generate a return.
- Financing cash flow: the net cash generated to finance the company, including debt and dividend payments.
Positive cash flow means that more cash is coming in than going out, and thus your business’ liquid assets are increasing. Negative cash flow means the opposite.
It’s normal to experience a short period of negative cash flow when you are investing in growth, since you must first spend money in order to generate more liquid assets in the future. However, a sustained period of negative cash flow means that your business is running out of fuel, and you need to take action.
What is Profit?
In a nutshell, profit = revenue – expenses. It’s how much money your business is left with after you deduct expenses from your total turnover. Again, there are three main types of profit:
- Gross profit = revenue – cost of goods sold. This includes variable costs such as materials and labour, but not fixed costs such as rent.
- Operating profit = revenue – business costs. This figure includes fixed costs but excludes tax, interest payments on debt and income from investments that are outside the realm of the core business.
- Net profit = revenue – all expenses, including tax and interest.
It’s important to understand the difference between these three figures so that you can understand which costs have the greatest impact upon your net profit.
Which is More Important?
Both cash flow and profit are important to the long-term success of a business but in the short term it may be prudent to prioritise one over the other. It’s possible to be in profit and yet run out of cash, and vice versa. Both matter enormously, but which one is more important depends on your current financial situation.
For example, a business may turn a profit each month but if that money is tied up in hard assets then they may be unable to pay employees and suppliers, and thus will eventually be forced to cease operations. In this instance, the business should prioritise cash flow.
On the other hand, a business may have a healthy cash flow but fail to make a profit due to substantial debt. Here, it may be prudent to prioritise paying off the debt in order to become profitable.
When a business fails to generate a profit over a sustained period of time cash flow will be negatively impacted. It’s important to balance cash flow and profit carefully, but this can be difficult to do – especially when you’re a busy business owner with a lot on your plate. For this reason, it’s worth investing in a quality accountant who can help you to maintain a healthy cash flow whilst generating a profit without losing your mind in the process.