What percent of your company's revenues should you be bringing to the bottom line? 2%? 10%? 20%?
Are you happy with your current profitability?
Those are important questions to answer because profit is the number one generator of cash flow. And cash flow is the number one creator of a strong net worth for business owners. (And building a strong net worth personally, and in your business, is your ultimate financial goal. Not to mention that being profitable is fun all by itself.)
Today I want to share a 5-minute process to help you answer those two very important financial questions. The goal of this 5-minute process is to come up with an estimate of what your annual profit should be (or could be).
Your estimate doesn't have to be right. It just needs to be a number you can write down. You will have plenty of time later to explore your estimate in more detail to determine if it should become your new profitability target.
The 5-Minute Exercise
Here's the exercise. You have 5 minutes to come up with an estimate of how much money you should make each year in your business. Here are the steps:
Look at your pre-tax income (your profit before income taxes) for the last twelve months. Divide that number by your revenues (total sales). Jot that percentage down. Let's say that revenues are $10,000,000 and pre-tax profit is $500,000. So the percentage is 5%.
- Look at your gross margin (gross profit dollars divided by revenues). Use that percentage to lookup your pre-tax profit target range in the chart below. Let's say gross profit is $4,200,000. So the gross margin is 42%. The pre-tax profit range in the table is 15% to 20% of revenues.
- Pick a pre-tax profit percentage in the range and multiply that times revenues. Write that number down. In my example, I'll choose 15% (to be conservative). That number times $10,000,000 in revenues is a pre-tax profit target of $1,500,000.
In that exercise, based on my example, the profit target is $1,500,000 and the actual profit is $500,000. The Profitability Gap is the difference, or $1,000,000.
Remember, it's just an estimate… for now. You will have time to more fully analyze that number later.
You should be able to come up with an estimate for your company in 5 minutes or less. Try it.
But Philip, What About…
I know. I know. You have questions. J
Where did those target percentages come from? Did you pull them out of thin air?
Fortunately we have lots of great examples of companies operating in those profit ranges (and even higher).
I'll talk more about that (and this exercise in general) in upcoming posts.
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