Profit and revenue are pretty basic terms when taken at face value. The picture becomes a little bit less clear when you apply them together and try to understand their relationship to your business and growth. A simple equation to understand the relationship is PROFIT = REVENUE – EXPENSES. The proportion of profit to revenue is your profit margin. Seems pretty simple and straightforward, right?
I’ll give a couple of examples to get started. Let’s say that company A has $50,000 of revenue each month with $30,000 of expenses. And company B has $30,000 of revenue and $10,000 of expenses monthly. Both companies have the same monthly profit, but company A has much more expense to achieve that profit. Company B clearly has a better profit margin (67% vs 40%).
So which company is in the better position for the future? Both companies have the same profit, but company A has more revenue. Having more revenue will theoretically allow company A to borrow more. (Have you ever noticed that business credit card applications only ask for the company’s revenue, not profit?) Company B has less expense and needs to make less revenue each month to be profitable. Both positions have benefits, but which is right for you and your company? I believe that company B, in general, is in a better position for future growth because their cash-flow needs are less, allowing them more flexibility and time to grow.
It’s important to think about the profit vs revenue picture when considering new business opportunities or significant new features to your existing business. If the new ideas will get you an extra $10k/month in revenue but will also result in $10k/month of new expense, are you really any better off? What good does increasing revenue do if profit does not also increase? At that point you are just moving from being company B to being more like company A. You have just decreased your margins and taken on new expense. The new expense opens you up to more cash-flow risk.
I would argue that a company that can qualify for more credit, like company A, will at some point need to take on more debt than a company that can’t qualify for as much. If your company produces widgets and has pretty significant cash-flow needs then you may benefit significantly from the added security that available credit would provide. If your margins are high then most likely your cash-flow needs aren’t as great, so available credit wouldn’t help you tremendously. I should make it clear here that I believe in a business having as little debt as possible, but the reality is that many small businesses with lower profit margins will need to rely on available credit at some point; more so than their higher margin brethren.
I suggest the following for all businesses: try to increase your profit without having to significantly increase your revenue. Each incremental improvement in your profit margin improves your cash-flow situation, which is the lifeblood of any business. For companies like company A, you first try to reduce expenses. If that doesn’t yield significant results then it’s time to look at your product offering and see if you can realign to improve margins. For companies like company B, you don’t have as much expense to eliminate, so try to grow your revenues without increasing cost.
This article was originally posted on our company blog. I’ve updated it slightly for this audience.