Rainbow Cake - Because I couldn't find a great picture for this post
Ever had the feeling when you think you know something, because it’s so simple in theory, until one day you don’t because you have to put it in practice?
Like knowing how to make an omelette.
In theory, its fairly simple. Pour well whisked eggs on hot pan, add salt + pepper and voila!
In reality, you could be stuck forever when it comes to breaking the eggs. By the time you get the basics right and get to adding tomatoes, onion, herbs, etc you are already a veteran.
I find this analogy fairly apt because I have found, over the last many years of waking up with a bad hangover in the homes of strangers, that even the most intelligent set of people can’t make good omelettes. And that’s because, while they possess a deep and unshakable confidence in their ability to make omelettes, in reality they just don’t know how to.
The reason why they are so wrong is because their template of a ‘Good omelette’ is flawed.
The same stands true for our understanding of profit. Unsurprisingly most ‘accounts/finance unaware’ entrepreneurs get it wrong all the time. The theoretical understanding of Revenue – Cost = Profit is good enough only when you are trying to impress your 10 year old niece/sister, who is trying to run a lemonade stand. And even she will probably get over it in a day.
I had the concept of Profit wrong, well after I had finished my MBA. I had slept through all my accounting classes and struggled with debit and credit to the point of antipathy.
So to benefit others who partied hard, slept in classes and are now embarking on entrepreneurism, I have decided to take up the issue of 3 profits and how we need to keep an eye out for all of them, while running a startup.
The 3 types of profit are
A. Gross Profit
B. Operating Profit
C. Net Profit
A. Gross Profit – The true representation of that cute ‘Profit’ formula for your niece/sister. To an extent.
Net Sales* – COGS ** = Gross Profit
*Only revenue from sales of goods/services and not other sources like selling off assets and investments. Also after deduction of sales allowances and discounts.
** Cost of Goods and Services i.e. the direct cost of making the product or delivering the service
Now this may look simple but how do you determine what is COGS, when the definition of ‘direct costs’ may differ based on how you apply them? Issues of when you recognize revenue are also important.
Anyway, the point here is that if you are in the red (-ve gross profits or gross loss) here, then one or more of the following may be the case
1. You are still trying to negotiate better rates with vendors for input/raw material costs. You have an idea of what it will cost when you have negotiated good deals with vendors/suppliers and are supplying customers products based on that cost.
2. To acquire customers and entice channel partners you are offering a lot of discounts to them to make your product/service available or to get potential customers to try them. You plan to increase prices once you have a good base of customers.
3. You hit a bad year and were getting rid of your inventory at heavy discounts.
4. You hit a bad year and delivered goods/services, promised in the past for a particular negotiated price, but now have to deal with higher input costs.
5. You are being a loss leader. Basically putting people out of business by offering cheaper products on the strength of your cash.
6. You messed up and don’t really know what it costs you to make a product/deliver a service
There are other reasons but if you suddenly realised that the last point applies to you, just stop here. Please go back and figure out the COGS of your company and read the rest. Chances are that if you have a gross loss instead of a profit then you are going to be in deep shit if you don’t take corrective measures soon. You will be -ve for the rest of the 2 profits by default.
To be sure, a number of well funded start-ups may be bleeding red here, but they are doing so just to get scale, reach or to develop the market (Points 1,2,4,5).
B. Operating Profits – This profit is the real deal when it comes to determining the health of your startup.
Now some people feel that Operating Profits are shown by EBIT = Earnings (Another name for profit) Before Interest and Taxes and others feel it is shown best by EBITDA = Earnings before Interest Taxes Depreciation and Amortization.
However you do it, this profit shows the amount of money you make from all operations related to selling of goods.
This includes, salaries, sales, marketing and other overhead costs.
If you are thinking of taking a loan on your business, then bankers will have a look at this metric since it shows them your ability to pay back the loan amount.
A healthy or slim Operating Profit Margin basically shows how healthy and efficient your company is. Slim margins are more susceptible to small changes in costs or other factors and can be maintained only when volumes are very high like in the case of Wal-Mart.
If you have a healthy Gross Margin but a bad Operating Profit Margin it could mean that your overheads are killing you.
However a slim or -ve Operating Margin may also mean the following
1. You are busy building assets and infrastructure for the future and have been loaded with the costs even after amortization and depreciation this year. This is when we used EBDITA to derive Operating Margins. Many startups, being pushed to develop assets to increase their valuation by investors may show -ve Operating Margins due to this.
2. You have scaled up well but the revenues haven’t followed just yet. This leads to higher overhead costs which are necessary since resources have to be maintained in anticipation of scaling up. So you could be spending lots on rent and salaries for now.
3. Your overhead costs are killing you. You have too many people, too much rent, too many things on lease, spending too much on supplies, maintenance, insurance etc.
Most startups feel comfortable being red in this regard as long as they have a good gross margin since most are concentrating on scaling up rather than hitting profitability just yet. They know that once the economies of scale catch up, they will start turning black in this part of the P&L as well.
C. Net profit – When we finally decide to subtract all costs of interest, taxation, depreciation, amortization and other charges from the Net Sales we get Net Profit.
Net income = Gross profit – Total operating expenses – taxes – interest – amortization – depreciation
This is where you get to know how much money you made during an accounting period.
So when someone asks you “What’s your bottom line?” This is the number you should ideally quote.
When talking to vendors, dealers other stakeholders this is the number you should be most interested in.
Having said that, most startups may take a long time before they show a profit here. That is because investors (VCs in particular) aren’t inherently interested in the dividends they make, but the valuation you show at the time of their exit.
So the next time someone, goes around mouthing fantastic profitability numbers at a cocktail party, be sure to ask him about all three of these. But before that, make sure you know these numbers for your own Startup and how your CA (hire one for heaven’s sake) got to them. Once you know them, understand why they are the way they are and where you would like them to be in the future.
You can be sure that once you know these three numbers, you will be on the ball about the health of your company/startup.
Hey! by the way, Profit is NOT the same as cash in hand. But that is for another post.
Startup Yapper 