Is your business really profitable?
In the latest UK200Group blog post Paul Hawksley, Managing Partner TWP Accounting, discusses the importance of understanding profitability
In its most simple definition, a business’s profitability is measured as its sales less costs. The annual profit of a business is the amount attributable to the owners of the business. In a typical owner managed business, the annual profit is the income which is attributable to the owners.
Arguably profitability is the most important measure within a business as the owners should get a suitable return for their investment of both time and money. Without profitability, the business cannot survive the long term.
In order to understand how profitable your business really is, you need to ensure that the annual profits are measured accurately. The starting point for most businesses will be the income statement included within their annual accounts. The income statement is calculated by including all of the sales made by the business during the period, then deducting the cost of sales and overhead expenditure.
However, this is not always a true reflection on the performance of the business due to the impact the following items which will not be reflected:
Owners / Directors Remuneration
Despite the facts that business owners often work well above the 40 hours per week, owner managed businesses often only pay a small salary to directors, with the remainder of their remuneration comprising dividends.
The income statement for the business therefore does not show the true cost of the owner’s time and efforts. In order to understand the real profitability of your business you should include an estimate for the fair market salary for the owner’s time. In a lot of businesses this may make the business unprofitable.
Assets owned by the business or owners
Further adjustments must be made for any assets such as premises owned by either the owners or the business directly. An appropriate charge for rent should be allowed for equivalent to what would be charged to an unconnected third party.
The value of assets is often discounted by business owners. I have recently seen businesses whereby the profits generated, which had free use of a property owned by the director were lower than the market rate of rent on the property. The owners would therefore have made more money by just leasing the property than running the business which took a huge effort, and arguably more risk and stress! The owner therefore spent a huge amount of time working for free.
Income recognition and cash basis
In order to provide a true reflection, the recognition of income and expenditure must be on consistent basis. Often small businesses recognise income despite the fact that there is still work to complete and therefore further costs at year end. It is therefore imperative to ensure that all outstanding costs are accrued for.
Having adjusted, for these items the key question that a business owner must answer is whether the profit generated by the business is a fair reflection for the demands of running the business?
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