A few weeks ago, I was at a cocktail reception attended primarily by entrepreneurs and small-business owners who had not seen each other since last year. Each proudly discussed the growth in their top-line revenues since seeing each other in 2014. One boasted, “We did $2 million in 2013 and $2.7 million in 2014, and I'm pretty sure we’ll do over $3 million in 2015 if all goes as planned!” The other replied, “Well, we are also growing rapidly, and top-line sales should be up by over 20 percent this year if all the stars align.” Then they toasted each other’s success with a great glass of wine.
Sounds good, right? Not even close. Small-business owners who hyper-focus on top-line sales are often missing what’s most important: the growth in the quality and the durability of the profit margin—the amount you ultimately take home to your families and that grows your net worth and overall enterprise value. In only a few exceptions are companies valued as a multiple of revenues (e.g., software companies and some types of technology companies); most are still valued as a multiple of earnings or EBITDA (Earnings Before Internet, Taxes, Depreciation and Amortization). So, what’s the bottom line on the bottom line?
A New Focus
It starts with a focus on profits over sales. Revenues for the sake of growing new revenues rarely serve much purpose if they're not tied at some point to new profits.
How can you change your focus from top line to bottom line? Try adopting some of these traits many profit-minded entrepreneurs have in common.
- They're focused on bootstrapping when it comes to costs, efficiencies when it comes to operations, and quality over quantity when it comes to customer development.
- They're more interested in deepening their relationships with existing customers than they are in spending a lot of money to attract new customers or enter new markets that may not be as profitable.
- They tend to hire or replace existing workers slowly and carefully and are quicker to take action on a non-performing team member unless there are compelling extenuating circumstances.
- They have the discipline to develop annual budgets tied to specific business goods and objectives and then spend wisely to ensure that goals are met. All costs are put through a series of screens and filters to ensure alignment with the budget and the company’s business plans and target milestones.
Profit-minded leaders also regularly ask themselves the following key five sets of questions:
1. Find the Hidden (Variable) Costs. What percentage of your monthly expenses is tied to variable costs? Do you see regular fluctuations in the costs of materials and supplies? What about sales and marketing costs? For some small-business owners, this is the single most important area of focus in trying to drive profitability.
2. Focus on Certain Economic Indicators. Which of the economic indicators are important to your business and/or industry? If you’re a retail business, for example, consumer spending, unemployment, housing and lending indicators might be ones to watch, particularly in your region versus the rest of the country.
3. Know Your Customers. Who are your customers and how do they use your product or service? What economic changes would make them buy more or less of your product? How will this affect your profitability?
4. Know Your Competition. What's the state of competition in your marketplace? One of the biggest mistakes a small business can make is not accurately and honestly assessing the competition. If too many good alternatives are available to the target consumer, that can have a big effect on pricing and profit margins.
5. Learn From the Past. With a business that is at least two to three years old, you have a track record of sales, expenses, cash flow and seasonal adjustments. By keeping proper business records and plans, you can greatly increase the chances of improving the profitability of your business model. Not all past performances will reflect future business conditions, but it should help paint a clearer profitability picture.
Andrew J. Sherman is a partner in the Washington, DC, office of Jones Day, an adjunct professor in the MBA program at the University of Maryland and Georgetown University, and the author of 26 books on the legal and strategic aspects of business growth and capital formation.
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