Understanding Your Finances: Profit Margins (2024)

Understanding Your Finances: Profit Margins (1)

Profit Margins

In my experience most firms collect loads ofmanagement information(MI). However, only a few use it to provide insight into what’s happening within their business.

Ask any adviser about their MI and they’ll usually tell you their assets under management, monthly income or annual recurring income figures. While it’s important to know this information, it really only provides a helicopter view of your business’ results; so if you want to fully understand how your business is performing, you’ll need to go deeper. Remember, the aim of doing any financial analysis is to generate insight to enable you to improve future decision making.

As a starting point, there are three critical figures that you must understand in order to improve the performance and profitability of your business:

a) Gross profit margin

b) Overhead percentage

c) Net profit margin

Let’s start by understanding gross profit margin:

Gross profit margin is critical. Without a suitable level of gross profit margin, you have no chance of ending up with any net profit.

Turnover – Direct Expenses = Gross Profit

Direct expenses (sometimes referred to as cost of sales) includes all remuneration paid to advisers and directors that sell to clients, including:

  • Commissions and salary + national insurance
  • Car allowances
  • Bonuses
  • Pension payments
  • Directors’ drawings

Direct expenses would also include any pay-aways to introducers, if you make them.

The money paid to sales people, selling directors and introducers/referrers is taken from your top line revenue first, which means that the business can only pay its other overheads (rent, equipment, wages for other staff, etc.) from the balance remaining.

In many firms, self-employed advisers are paid 50-60% of the gross revenues they bring in, which is both unsustainable and often a contributing factor to poor net profitability.

Ideally, direct expenses should not exceed 40%, leaving you with a minimum gross profit margin of 60%. Remaining overheads should not exceed 35%, which leaves a genuine net profit margin of 25%.This should be your aim.

When you do this analysis for yourself and look at the three critical figures, you will realise that keeping your business overhead to 35% is no mean feat in itself, so if you are not careful, paying away more than 40% of your gross revenues will leave you severely profit-squeezed.

Gross profit÷ Total revenue= Gross profit margin

For example:

Turnover:£500,000

Less direct expenses:£200,000

Gross profit:£300,000

Gross profit margin:60% (£300,000 ÷ £500,000)

Pitfalls

It is highly unlikely your accountant or internal bookkeeper prepares your monthly accounts using this formula. Even if they do, what figure do they include for working directors’ remuneration?

In many businesses, owners will take minimum levels of tax-free salary and additional monthly drawings which are accounted for (at year end) as dividends from profit. Whilst this is fine from a tax planning perspective, if you receive regular financial information in this format, you’ll have no clue as to how your businessis really performing.

Following on from the example above, let’s assume we have two owner/directors in the firm who each generate £250,000 of annual revenue, but only draw £10,000 each of salary.

The annual accounts now look like this:

Turnover:£500,000

Less direct expenses:£20,000

Gross profit:£480,000

Gross profit margin:96% (£480,000 ÷ £500,000)

Clearly this isn’t an accurate reflection of what you are really drawing as owner/directors and now your gross profit margin is overstated.

By including a more accurate figure for directors’ remuneration (£100,000 each in the first example) we get a true reflection of this aspect of the business’ performance.

The same trap applies if you take annual remuneration that is less than a genuine market salary.

Let’s say that both directors in our example drew just £60,000 each of salary and dividends per annum. Yet, with £250,000 each of annual revenue they could almost certainly take their client bank down the road to a competitor and receive far higher levels of remuneration (let’s assume £100,000).

Understanding Your Finances: Profit Margins (2)
A common (and often frustrating) occurrence while a firm is still growing, is for the owners to act as the bank!

The real problem here is that when the owners take a cut in salary, the profit issue doesn’t look as bad, so the owners convince themselves that everything is fine.That is, if cash flow is tight, they take less than market remuneration, while everyone else that works in their business (back office staff, paraplanners) gets paid their full going rate.

In the example below we will assume that overhead is above the recommended benchmark of 35%(as is usually the case in smaller, growing firms).

Look a how this plays out and creates a misleading impression for the owners:

Turnover:£500,000

Less direct expenses:£120,000

Gross profit:£380,000
(Margin = 76% or £380,000 ÷ £500,000)

Less overheads:£275,000
(Percentage = 55% or £275,000 ÷ £500,000)

Net profit:£105,000

Net profit margin:21% (£105,000 ÷ £500,000)

The net profit figure appears to be an acceptable 21%, but it’s actually quite misleading.If we substituted the real market salary for both owners (£100,000 each) the net profit figure drops to just 5%.

What’s the harm, you might say?These owners are running a small advisory business and essentially earning £112,500 each(if you split the drawings and profit between the two of them). However, I would argue that:

  • £112,500 is their basic wage for doing the job, which they could just as easily earn working 9am – 5pm down the road with a competitor; which would also eliminate the stress that running a business places on them and their families.
  • With increasing capital adequacy provisions, lack of profitability makes complying a potential headache in the future.
  • Owners of businesses need (and deserve) to be compensated adequately for the risks they are taking.
  • Real businesses make profit, some of which is distributed to shareholders for their capital at risk and some of which is reinvested in the business each year (in better people, technology, marketing etc.) to allow it to continue to grow.

A clear understanding of your gross profit margin is an essential step in increasing the profitability of your business.

Want more help understanding your numbers?

Take a look at my self-study video coaching bundle, Analaysing Your Financial Ratios.

Did you know there are two other important sets of financial ratios that you need to understand in a financial planning business:

  • The Productivity Ratios
  • The Client Selection Ratios

When taken together, these numbers provide amazing insights that let you make better decisions.

For example, if your business isn’t as profitable as you’d like, where is the squeeze coming from?

  • Do you pay too much away to advisers? (which shows up in your Gross Profit)
  • Are your overheads too high? (which shows up in your Overhead Percentage)
  • Do you have too many staff for a business your size? (which shows up in the Productivity Ratios)
  • Are your advisers producing at the right level? (which shows up in the Productivity Ratios)
  • Do your clients pay enough in fees? (which shows up in the Client Selection Ratios)
  • Is your average client size going up, down, or staying the same? (which shows up in the Client Selection Ratios)

Understanding your financial ratios provides a clear and simple diagnostic tool, so you can be working on the right issues. I’ve seen too many adviser owners grinding away year after year, but on the wrong issues. It breaks my heart.

If you want some more help with your pricing, or communicating your value effectively, or diving deeper into the profitability ratios and how to fix them, then check out the full range of self-study video coaching bundles here.

I’ve got a bunch of video modules that will help you knock your business into outstanding shape. Each module comes with workbooks, tools, templates and cheat sheets to get you solving issues quickly. You can find more information here.

Understanding Your Finances: Profit Margins (2024)

FAQs

How do you answer what are your margins? ›

Gross profit margin.
  1. Gross profit = revenue – cost of goods sold.
  2. Gross profit margin = (gross profit ÷ revenue) x 100.
  3. Operating profit margin = (operating profit ÷ revenue) x 100.
  4. Net profit = revenue – cost of goods sold – operating expenses – interest – taxes.
  5. Net profit margin = (net profit ÷ revenue) x 100.

How do you understand financial margins? ›

Expressed as a percentage, it represents the portion of a company's sales revenue that it gets to keep as a profit, after subtracting all of its costs. For example, if a company reports that it achieved a 35% profit margin during the last quarter, it means that it netted $0.35 from each dollar of sales generated.

How do you determine what your profit margin should be? ›

Generally speaking, a good profit margin is 10 percent but can vary across industries. To determine gross profit margin, divide the gross profit by the total revenue for the year and then multiply by 100. To determine net profit margin, divide the net income by the total revenue for the year and then multiply by 100.

Is a 40% profit margin good? ›

The 40% rule is a widely used benchmark for assessing a startup's financial health and the balance between growth and profitability. This rule of thumb emphasizes that a company's growth rate and profit, typically represented by the operating profit margin, should collectively reach 40%.

What are examples of good profit margins? ›

The average profit margin for a small business varies by business type. For example, online retail companies have about 41.5% gross and 7.2% net profit margin. For restaurants, these numbers average 31.5 and 12.6%. Healthcare companies have an average gross profit margin of 59% and net profit margin of 13%.

What is a healthy gross profit margin? ›

On the face of it, a gross profit margin ratio of 50 to 70% would be considered healthy, and it would be for many types of businesses, like retailers, restaurants, manufacturers and other producers of goods.

Why is it important to understand profit margin? ›

The Importance of Profit Margin

Companies use their profit margin as a way of determining how profitable and healthy they are. The higher their operating profit is, the more secure they will appear in their overall industry.

What is the most important margin in finance? ›

The three main profit margin metrics are gross profit margin (total revenue minus cost of goods sold (COGS) ), operating profit margin (revenue minus COGS and operating expenses), and net profit margin (revenue minus all expenses, including interest and taxes).

What is the difference between profit and margin? ›

Gross profit is the money left over after a company's costs are deducted from its sales. Gross margin is a company's gross profit divided by its sales and represents the amount earned in profit per dollar of sales. Gross profit is stated as a number, while gross margin is stated as a percentage.

How to figure out profit? ›

Profit is simply total revenue minus total expenses. It tells you how much your business earned after costs. Since the primary goal of any business is to earn money, profit is a clear indication of how your company is functioning and performing in the market.

Which business has the highest profit margin? ›

The products with the highest profit margins are those in which the cost to make something is significantly less than the price customers are willing to pay for it. Specialty products that speak to a niche market, children's products, and candles are known to have the potential for high margins.

What products have the highest profit margin? ›

17 best high-margin products and niches
  1. Watches. Pros of Selling Watches. ...
  2. Jewelry. Pros of Selling Jewelry. ...
  3. Women's Clothing. Pros of Selling Women's Clothing. ...
  4. Fitness Equipment. Pros of Selling Fitness Equipment. ...
  5. Kids' Toys. Pros of Selling Kids' Toys. ...
  6. Candles. Pros of Selling Candles. ...
  7. Hygiene Products. ...
  8. Pet Care Supplies.
Apr 8, 2024

What is a reasonable profit margin for a small business? ›

But in general, a healthy profit margin for a small business tends to range anywhere between 7% to 10%. Keep in mind, though, that certain businesses may see lower margins, such as retail or food-related companies. That's because they tend to have higher overhead costs.

How to set profit margin? ›

Determine your business's net income (Revenue – Expenses) Divide your net income by your revenue (also called net sales) Multiply your total by 100 to get your profit margin percentage.

What is an example of a margin? ›

Net Profit Margin = Net Profit ⁄ Total Revenue x 100

The result of the profit margin calculation is a percentage – for example, a 10% profit margin means for each $1 of revenue the company earns $0.10 in net profit. Revenue represents the total sales of the company in a period.

What are your margins in business? ›

In the business world, margin is the difference between the price at which a product is sold and the costs associated with making or selling the product (or cost of goods sold). Broadly speaking, a company's margin is its ratio of profit to revenue.

What do you write in the margins? ›

Marginal notes may include key words and phrases, summaries of important points, questions, and judgments. Readers who become seriously involved in what they are reading may engage in a kind of con- versation with the author, a conversation which leads to the discovery of their own attitudes and beliefs.

What is margin in your life? ›

Margin is the space between our load and our limits. It is the amount allowed beyond that which is needed. It is something held in reserve for contingencies or unanticipated situations. Margin is the gap between rest and exhaustion, the space between breathing freely and suffocating.

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