How much money are you making?
This is a common and succinct question small business owners often receive, however crass it might seem. The question can feel like a dagger to the heart or a point of pride, depending on how you perceive your business is faring financially.
But how do you know how your business is doing? How do you know if your business is making money or not?
There are 2 main ways to understand the cash coming into your coffers: revenue and profit.
Revenue and profit are 2 systems of defining the money your business is making. Revenue is the top line, and profit is the bottom line.
Let’s explain these concepts, how they interact, and what they mean for your business.
What Is Revenue?
“Revenue” is synonymous with “sales” on many financial documents, and for good reason. Revenue is all the money your business brings in through its operations. For most small businesses, this means money earned from selling goods or services.
Revenue is the top line because it is all the money your company makes before subtracting any costs.
For many small businesses, especially new ones, revenue is critical. If your revenue is increasing over time, you know there is a demand for your product or services.
However, judging your business’ financial health based on revenue is a bad practice because revenue is too broad of a metric.
For example, suppose an auto dealership decided to severely undercut its competitors by selling new cars for less than it paid for them from the automakers. Revenue would likely skyrocket as consumers discover that its cars are much cheaper than anywhere else. However, the dealership would probably be in deep financial trouble because it would be losing money with every sale.
Still, there are no one-size-fits-all answers about whether revenue or profit should be your focus. In the above example, the dealership might decide the good PR gleaned from the happy customers will be worth more in future sales than the money lost during this price-cutting move.
What Is Profit?
Profit is the money you receive after subtracting expenses from your revenue. Analysts will also refer to profit as “income” or “earnings.”
Revenue is your company’s top line. Then, in your ledger, you subtract various expenses to receive your profit—your bottom line.
Profit usually refers to a positive bottom line. You are then “in the black”—a reference to how accountants commonly color-code their books. If your expenses are greater than your revenues, your profit is negative, although you would probably refer to this figure as a “loss.” Your business would then be “in the red.”
What expenses do you subtract to figure out your profit? There are several methods of computing this number. Gross profit is when you subtract the cost of goods sold (COGS) from your revenue. COGS are the direct expenses associated with each good or service you sell (i.e., the cost of manufacturing or acquiring your goods). This does not include indirect costs, such as rent for your office.
Operating profit subtracts overhead expenses like office rent or marketing from revenue along with COGS. Because of this, it might be a more holistic approach to analyzing your financial situation. There are even more ways to define your profit, like pre-tax profit or net profit.
Your profit margin is how much profit (or loss) you earn (or lose) with each sale; profit margin displays how your profit increases off of your revenue. To determine profit margin, take a version of profit (like gross profit or operating profit) and divide it by your revenue. This will give you the decimal expression of your profit margin percentage.
Is Profit More Important Than Revenue?
From an extremely generic standpoint, profit is more important than revenue for small businesses. However, there are huge exceptions to this rule, including whole industries.
“When it comes to investors, there’s a divide,” analyst Andrew Marder of software platform Capterra explains. “In the tech startup world, revenue is often seen as the end-all, be-all of finance. Venture capitalists look for companies that can ramp up revenue regardless of cost, hoping to figure that bit out later on down the line.”
Famously, Amazon, Uber, Zillow, and many other unicorns that define our modern life took decades to turn a profit—some still have yet to be out of the red.
But the circumstances are vastly different between an app startup and a small business in retail, hospitality, or professional services. In most cases, profit is a much more accurate indicator of a company’s financial health.
“In the world of more classic, Warren Buffett-style investing, revenue is almost meaningless,” Marder continued. “These investors—which may also include your business banker—want to see money making it all the way to the bottom of the earnings statement.”
The safest position is to pay continual attention to both revenue and profit—you can’t have any profit without revenue, after all, but you probably want to be spending less money than you are bringing in through sales.
How Do You Gauge Your Business’s Financial Health?
While revenue and profit are important components for diagnosing your company’s overall viability, more information is needed. The professional help of an accountant can be extremely useful for this.
“Looking at your bank account is a bad way to manage your business,” suggests CPA Shabir Ladha. “Many entrepreneurs do it because that’s the only piece of information they have. Having the right bookkeeping or the right information is vital for business health.”
When thinking about your company’s financial wellbeing, you also need to consider expenses, cash flow, and less tangible factors like branding or public perception.
How Do You Increase Profits and Revenue?
From a mathematical perspective, you increase revenue by making more sales. You increase profit by increasing revenue, decreasing expenses, or both.
Easier said than done! But that is the task of running a small business. With planning and research, you can best chart a path to thrive financially.