A business either earns a profit on every dollar sold or they don’t. The profits in every business are what’s left over after expenses are deducted from Net Sales. The business profit equation is Net Sales minus expenses equals Net Income or Net Profits.
Whenever a business fails to earn a profit, it’s reflected in the P&L Statement as a negative number. Negative profits are always a problem. They are particularly business-threatening when they involve negative Gross Profit.
Overview
The survival of every business of any size is shaped by how good they are at selling a product or service at a profit to people who have a need to be served or a want satisfied. The ability to persuade target customers that you can solve their problems better than competing alternatives for their money and time is how you maximize sales and profits. The bottom line for all business models is to deliver your offer at a price that earns you an ever-improving profit.
Making this strategic decision is easier when you understand how a business makes money. Below is where you see on your P&L Statement the three levels of business profitability:
First level of business profit is Gross Profit. Gross Profit measures your first level of profit contribution that comes from transforming a dollar of sales into a profit. Without a strong gross profit in your business operations, it is impossible to have a strong Net Income number.
Second level of business profit is Operating Income. Operating Income or EBITDA earnings are calculated from the company’s Gross Profit, less SG&A, or overhead expenses. EBITDA is a financial term that stands for Earnings Before Interest Taxes Depreciation and Amortization.
Third level of business profit is Net Income. Net Income is the end financial result. It is also referred to as the Bottom Line of the P&L Statement; after all, expenses are deducted from net revenues earned during that same period. It is the only number that transfers from your P&L Statement to your Balance Sheet. Yet, it’s your third level of profit, because it is a “lagging number,” generated after every expense has been deducted from Net Sales.
Net Income is the hardest number to impact given its high reliance on the results of sales and operations reflected in Gross Profit and business admin that shapes Operating Income. Again, the most business-sustaining method to increase the bottom line is to increase Gross Profit while not wasting money on overhead.
The other way to increase Net income is through Nonoperating Income also referred to as Other Income representing any inflow of monies from earnings or payments received that is not directly attributable to the company’s core business operations. Nonoperating income usually does not occur on an ongoing basis making it next to impossible to rely on as a lever for increasing Net Income.
The ultimate measure of business performance is how well a business extracts profits from its sales through its operations. Measures, indicators, and metrics are how you confirm how well your business does this through your profit quality.