Think small businesses generate small business profit? Keep reading to discover why you should probably think again.
As a small business owner, you probably have a very straightforward philosophy: I need to make money!
Most of us left corporate to add true value and meaning to our lives while improving the quality of that life. But, at the end of the day, if we cannot generate a profit, then we’re sunk and might have to (it’s okay to cringe) return to the corporate life.
There is, thankfully, this little but powerful metric that could have you making big changes fast.
It’s the EBIT metric and it may be just about the most important metric you’ll ever learn.
Don’t just take our word for it….
Here’s what some of our Build Live Give community members had to say about why they recommend and use EBIT as a key metric:
Note that not everybody recommends it as a metric:
That’s perfectly OK, and it does indeed come down to your specific business needs.
We actually recommend 9 profit ratios for small business owners to keep an eye on (more on this soon), but for now let’s talk about why we recommend EBIT to most business owners as the primary one.
Imagine if you could literally calculate where your rendered service might be lacking. You’d have a constant and accurate formula for course-correcting your business, right?
What you may think of as your small business profit may turn out to have way more potential than you think.
What is EBIT?
Every business wants to be profitable, and profit, as most of us understand it, means a financial gain, particularly in the context of earning and spending. That is, profit is the margin between revenue before expenditures and after expenditures.
Calculating profit seems a simple enough formula (albeit, a rather daunting task sometimes) but basic profit margins don’t necessarily reveal a company’s value. Intriguing but scary.
If you’ve ever heard of and/or set aside the time to learn about EBIT, then take this moment to pat yourself on the back.
*Pat, pat* (Okay!)
EBIT, or Earnings Before Interest or Taxes, is a measure that doesn’t merely calculate money coming into a company and the money going out. This formula more specifically calculates what profits you do make solely in relation to your operations.
Think of it as, How much money do my labor and service make? So, the EBIT calculation ignores, so to speak, factors like interest expenses or taxes, for example.
It’s the calculation that cuts to the chase and that can help give you an instant snapshot of your company’s earning potential. This can come in handy if, let’s say, you’re trying to gauge the growth potential of a prospective company you’re looking to buy.
This “instant snapshot” can be especially effective in looking at companies across different industries as well as from across the world. Differing tax and environmental laws, various capital structures (i.e. how a company finances itself), etc. are all factors that can make it difficult to see the true profitability potential of a company.
Is this company’s profit margin so high because it is actually bringing in a high revenue, or did it simply receive a lot of tax breaks this year?
This other company does seem to revenue a great deal but how much volume (and, therefore, expense and labor) is required to at least break even?
You obviously know that you want to be increasing the gap between your gross income and your net income. Plainly and simply, EBIT can help you determine how much of that gap is caused by the organic growth of your business.
That is, how valuable is the service that you are rendering? Are people willing to pay top dollar for it?
Why is EBIT important for small business profit?
The EBIT calculation is a good history lesson of your company’s performance.
If you can clearly look back on the results your business has, so far, generated, you then have the ability to pinpoint exactly where your operation is taking its hits.
Because of the nature of EBIT (calculating your profitability based on your service and performance alone), any factors that need changing are generally within your complete control.
If over a long period of time, there’s no change in the EBIT ratio of your business, you may want to rethink your business model.
EBIT is, however, what you could call a “lag measure.” That is, the formula shows you only what has happened. And, you already know that you can’t change what has already been.
“Lead measures” are, on the other hand, calculations or moves you can make in order to directly affect the future. That’s good, yes? But, keep in mind it’s difficult to be effective if you don’t know where to begin.
This is where the marriage between lag and lead measures is crucial. Use your “lags” to determine which “leads” to take.
The more you do so, the easier it is and the faster it becomes to produce strong effectiveness in your business’ operations. Ergo, faster and better profits.
How do you measure EBIT?
The EBIT formula is quite the generic calculation in the sense that it can become rather broad. You actually have a few options in trying to calculate this which may make it difficult when looking at specifically comparing your company to others across your industry.
Some industries require a massive volume of sales simply because they make a small profit per single item sold.
A coffee shop, for example, isn’t going to make much when a customer buys a 2-dollar drink, especially if rent costs a few thousand dollars a month. A typical McDonald’s restaurant, as another example, needs to service an average of 1,900 customers a day in order to be profitable.
Other companies may not even need so high of an income to have a large EBIT ratio.
For example, selling an online course for $200 doesn’t necessarily require a long expenditures list. Plus, this is a product that need only be made once but sold countless times.
That being said, you can simply just subtract your operating expenses from your total revenue. But, keep these next few things in mind.
Things like one-time costs or inhabitual expenses that don’t necessarily relate to your core operations don’t have to be included in your EBIT. Think of items like an unexpected lawsuit or a partner buying you out; they don’t figure into the regular assets and liabilities of your daily business.
Exclude, of course, your non-operating expenses. These can be described as income from an investment for instance. Interest income, on the other hand, may be included in your EBIT but that depends on its source.
If, for example, it’s part of your business model to extend credit to your clients, then this is an integral part of your operations, and so can be included as an operating cost.
If, however, your interest comes from an actual investment, like a bond or income fund, or perhaps you charge fees to clients for overdue payments, those interest incomes typically do not count and can be classified as non-operating expenses.
To give you an idea of a couple of EBIT ratios, the service business’ generates on average a 10-20% EBIT ratio.
For those of us who didn’t work in the finance department in our corporate days: for every $1 you spend in your business for the sole purpose of rendering your service, then you’ve made between $1.10 and $1.20.
For those of us in BLG Titans that ratio is about 25-30%.
Playing accountant is worth your time. Numbers may not be all that attractive but they get to be really fun when your spreadsheet shows your business in the black.
EBIT is an accurate and straight-forward way of getting to know your business. Using this metric alone can help you improve your model to no end thereby expanding your small business profit as well.
Practice it; try out the different variations to see what you come up with. Once you get the hang of it, your operations will become that much more effective.
We may not all be fans of numbers, math, spreadsheets, what have you, but making a significant amount of money doesn’t suck.