Make sure that your margins make sense. Giving away your product or service will never result in a profitable operation. It might work as a short-term start-up strategy, but it won’t keep you running long-term.
I am by no means a financial expert. Let’s just get that out of the way. What I can tell you is that making sales is not the same as making profit. I’ve spent years and many businesses trying to persuade myself that I had a viable business when I wasn’t paying myself a salary or I was working out of my mom’s dining room.
The very subtle and often misunderstood difference between three key terms can quite literally sink your business. You think you’re making money but you’re spending it as quickly as it’s coming in and your business model is broken.
The simple thought that should be in your head is that you should be selling something for more than you purchased it. So much more that if you sell enough of this product you’ll actually make a tidy profit after all of your expenses.
The very first and most important thing that any business needs once there is a product, is sales.
It’s pretty important to understand that if you aren’t making sales, your business isn’t going to be profitable, ever. Sales lead to income and hopefully income leads to profit.
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When I started out in business I thought the equations were simple. I made a sale, I did the work, I was paid for the work and then I had money in the bank. In an ideal world, this is exactly how it should be. But it’s not that way at all.
Your sales equate to your turnover. Turnover is the money that came into your business through sales, as is, no strings attached. If you sell something for R200 then your turnover is R200. Simple.
Making and spending money
Things get a bit tricky when you talk about gross profit. Everything that is sold — time, products, anything — has a cost. If you buy a product at wholesale for R100 and sell it for R200, your turnover is R200 but your gross profit is R100.
Your cost of goods sold (COGS) or cost of sale (COS) are the two figures you use to calculate your gross profit. Turnover minus COGS/COS equals gross profit.
Gross profit is a dangerous term because it can mislead entrepreneurs. You think that the word profit in there is meaningful but it isn’t yet. It’s just a reflection that the product you make, buy or sell is actually being sold for more than you purchased it. This is a decent start but still not the whole picture.
This is the Holy Grail. Net profit is the one that matters. It is using all of your expenses. This is the figure you are left with once you minus all of your expenses. Your bandwidth costs at the office, your rent and everything inbetween. If you are making a gross profit of R100 at the end of the month and all of your expenses equate to R50 then you are left with a net profit of R50.
It’s important to take all of your expenses into account for net profit. You cannot be a profitable business if you aren’t paying yourself a salary, or accounting for rent. You get the picture.
Why this all matters?
You’re a start-up and you are making a huge amount of sales each month. Your bank account looks and feels full. The money keeps flowing in but you don’t notice that the money is flowing out just as quickly.
Your cash flow is killing you and you aren’t focused on it. You’re focused on top line revenue, your turnover, when you should be looking at the bottom line, your net profit. That’s the line that keeps your business in business. If the money is leaving your account faster than it’s coming into your account you are burning cash.
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If your cash burn exceeds the amount of money in your bank account, you are technically out of business. That’s why this terminology matters. They aren’t just words, turnover, gross profit and net profit can keep you alive or quickly destroy your company.