Today we are going start optimising your income statement while keeping the theories we learned in the past few weeks in mind.

Optimisation is important because using a structured approach to improve your business will increase your cash flow and also increase the business value to a potential buyer.

Return on Equity = Net Profit After Tax / Equity

Net profit is from the income statement and equity is from the balance sheet. Most people fail at increasing their business valuation because they focus only on optimising the income statement. We are going to look at both the income statement (this newsletter) and the balance sheet (next newsletter).

A lot business owners are leaving money on the table by not optimising their income statement.

In this edition we will look at:

• Keeping sales strong

• Understanding the cost of sales

• Minimising expenses

• Interest and taxes

Keeping sales strong

Generally speaking, sales has two components, the price of the product and the volume of the product sold.

Sales = Price x Volume

Price is affected by a number of factors, such as supply & demand, competition, inflation, etc. These factors are different for each industry, so while we cannot give general advice on pricing, we can look at the mistakes to avoid.

Pricing Sin 1: Discounting for market share

Commoditised industries are the type of industries where you can buy products from different parties which are very similar. We are not only referring to commodities such oil, coal and gold. It can also include products like cars and pizzas.

In a commoditised industry companies often discount to gain market share. What this does is instantly reduce the price of the product for the entire industry.

Let’s imagine this scenario. Your local car dealer offers discounts on new cars. Instantly, every single dealer (of that brand) in the greater area has to meet these terms. If not, the discounting dealer will start attracting all the business. The only way to get customers back is to offer comparable discounts.

This situation can quite easily turn into a price war and reduce profitability for everyone in the industry. Also, once you have sold a car for less, it is very hard to justify increasing the price again. Why pay more for the same car this week vs. last week?

Competition will naturally put pressure on prices. But never discount just to get market share. You can destroy your entire business.

Pricing Sin 2: White labels

Retailers often want to make their own in-house brands, so they go to the branded manufacturer and ask them to white-label a similar product which will become the store brand. They promise to buy large volumes from the manufacturer, so they want a very good price on the product. Normally, lower than the branded version. The manufacturer complies.

The retailer then places their new in-house brand on the shelves and positions it so that it competes with the branded product. It is usually a reasonable alternative, so customers buy. Branded product sales suffer. The branded product price must reduce to compete.

In this scenario, you have just helped to destroy the profitability of your own product by white-labelling and manufacturing a store brand that will compete against you.

This is a tough place to be because retailers will often seek out contract manufacturers who will make the store version. Your only defence is brand value.

Understand the cost of sales

A lot of small businesses don’t put a big effort into understanding their cost of sales. Yet this is the biggest driver of the company’s profitability.

Gross profit = Sales – Cost of Sales

Gross profit (GP) tells you how much of money you make every time you sell a product. But it is not the end of the story. The gross profit is then used to cover expenses, interest and taxes.

Gross profit margin (%) = Gross Profit / Sales

Let’s imagine that your gross profit margin is 50%. If expenses, interest and taxes take up another 40%. Then your Net Profit after Tax will be 10%.

If you want to maintain that level of net profit, you have to maintain your gross profit margin. If your gross profit margin drops to 40%, your net profit margin will drop to 0%.

You need to understand gross profit right down to product level. You must know what margin you are achieving on each and every product. Why?

Let’s imagine this scenario. A retailer wants to buy your products. Retailers are notorious for negotiating hard because they have buying power and are often your main distribution channel.

If you know your gross profit margin and the minimum level you need to keep your business profitable, you know how much of a discount you can let them negotiate. If they push you into negative gross profit, it is not worth selling them the product.

Another trick retailers use is to buy products in bundles (multiple products) and then squeeze the bundle price. This feels like good business because you are selling multiple product lines, but if you don’t understand the costing of each item in the bundle, you might be sacrificing the profitability on your best products.

Use cost of sales to calculate gross profit, so that you can understand your product pricing levels.

Minimise expenses

After sales and cost of sales, the next item on your income statement is selling, general and administrative expenses (SG&A).

You know your business, so you know that you have to minimise expenses. There is not much generic advice to give, except for two things.

Firstly, all businesses get a little fat in good times. Then they struggle in the bad times. Review SG&A, there is always some excess that can be cut.

Secondly, beware of sacrificing expenditure on marketing when business is down. Remember, you need a strong brand to fend off competitors and to promote sales.

Interest and taxes

Interest paid is a function of the rates available on loans. You pretty much have to take what is on offer in the market at the time you take the loan. But don’t be complacent, if interest rates drop significantly in the market, refinance and lock in lower rates.

For most small businesses there is not much tax optimisation that can be done because the rules are fairly clear. Make sure that your accountant is taking every deduction allowed. Sometimes these things can get missed, especially if you outsource accounting.

Also, double check if you are not sure about something being deductible. Sometimes deductions are disallowed. But in rare cases, there are provisos to these disallowed deductions. What that means is that generally speaking a deduction is not allowed, but in very specific cases it will be allowed.

Your accountant may not come across the specific cases often and miss a deduction. So ask around if you are in doubt. Tax law is very intricate, this can happen.

Conclusion

Sales is the biggest driver of value in a business. Make sure that you are optimising it. Then make sure that you optimise everything below that in your income statement. If you do this, your Net Profit after Tax will be maximised. This is a good start to maximising your return on equity.

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