Profitability is undoubtedly the most important aspect of running a business. Almost all entrepreneurs recognize this when they first launch their business, yet most find that their business models evolve as they grow, making it difficult to grow profits consistently.
As a result, many entrepreneurs find themselves in a race to the bottom, as they begin to focus on using revenues to keep up with expenses, instead of produce profits.
The sobering reality is that cash-flow management plays a critical role in the sustainability of any business. In fact, an estimated 90 percent of small businesses fail due to cash-flow problems. And since most business owners aren’t CPAs, they often have trouble figuring out how to create a sound business model.
To get to the bottom of this issue, I sat down to interview Michael Michalowicz, a serial entrepreneur and the founder of Profit First, who argued that cash-flow problems result from flaws in generally accepted accounting principles. His insights, outlined below, can help entrepreneurs boost their profitability and bottom line.
The No. 1 mistake that hurts business profits
Interestingly, Michalowicz said that accounting may be viewed as an indicator of a business owner’s decision-making acumen -- or lack thereof. However, the equations governing the rules of accounting themselves offer little insight for entrepreneurs trying to make their businesses successful.
Instead, Michalowicz said he believed that entrepreneurs need to change their approach in order to develop profitable companies.
The basic rule of accounting states that net assets are the sum of liabilities and owner’s equity. This doesn’t hold much significance for business owners, because it doesn’t show how the owner’s equity is grown. The obvious answer is that businesses which generate profits grow their assets, which in turn, builds their equity (provided they aren’t taking on an unsustainable level of debt).
When you start to break things down this way, even the least financially adept entrepreneur sees the point. Unfortunately, he or she also finds that boosting profitability is much more complicated than simply understanding this principle. The mistake that entrepreneurs often make is to focus on building profits by boosting sales.
In theory, this makes sense. However, many business owners fail to recognize that higher sales result in higher expenses.
Some of those expenses are immediately obvious. Variable expenses, such as the materials needed to create the products, are clearly going to rise with sales. But other expenses can grow as well; increasing sales usually requires spending more on marketing, labor and efforts to penetrate markets that aren’t as likely to be profitable.
As a result, many entrepreneurs find that their profit margins contract as sales rise. If the situation gets out of hand, they may eventually find themselves losing money, as expenses grow faster than sales.
Michalowicz’s advice on improving profitability
Michalowicz cautioned that many business owners start by focusing on boosting sales and then seeing what profit they can earn afterward.
They may realize large profits from a few great sales, but growth will be inconsistent. This can be disheartening for entrepreneurs who want to create a profitable business model.
To combat this effect, he suggested a different approach. Rather than placing the emphasis on sales growth as a means to profitability, entrepreneurs should focus on profits first. They should set a minimum threshold for profits and focus on the sales that will help them consistently grow those profits.
A pattern of moderate, consistent profits is much more worthwhile over the long term than hit-or-miss profits from a few home runs.
Profit is your No. 1 priority
While all business owners recognize that earning a profit is the ultimate goal, their actions don’t always reflect that understanding. In addition to focusing on growing sales over boosting profits, they often make a number of other mistakes.
One of these, according to Michalowicz, is zeroing-in on paying off debts before the business becomes profitable. Being in debt can understandably be scary -- especially if the company isn’t lucrative yet. However, entrepreneurs who use their revenues to pay down debts too soon often fail to understand the opportunity cost of doing this.
What they don’t realize is that the revenue they’re generating is necessary to build momentum, to put the company in the black.
To avoid this issue, Michalowicz recommended appointing someone to hold you accountable for making the organization financially successful. In his own case, that person was his accountant. Obviously, a business partner or mentor could also work but might may fall victim to the same fallacies -- especially if he or she gets trapped in the day-to-day needs of running the business.
Accountants may not be known for their personalities, but they can be lifesavers for struggling entrepreneurs. To help other business owners avoid the problems described above, Michalowicz formed Profit First Professionals. This group is a team of more three dozen accountants and other professionals who help businesses focus on profitability.
Whether or not these particular professionals make up part of your business team, be sure to include somebody on your team who can help you hone in on your profit margins.
Related: How to Figure Out Your Margins