Do you understand revenues and profits? A Primer

So how did the meeting go?

My friend was in the process of hiring a private banker to help find a buyer for his business.

I thought it went really well. He liked what we’ve done so far and felt that there’s some interest in the market. However, he feels it’s really important to improve our EBITDA before we can get a good deal.

I almost fell out of my chair hearing what he said. Not because buyers would like a good EBITDA, but that my friend actually said this. The previous two years – we’ve known each other for 20 years now and he’s been in business longer – I’d struggled to get him to clearly state what his gross margins were and what was preventing him from having consistent profitability.

Of course, younger entrepreneurs – many of whom come from technology backgrounds – don’t have much exposure to matters of finance (or accounting). Yet having rudimentary financial literacy is critical, I’d argue, for all of us, entrepreneurs or not. Entrepreneurs, especially those NOT bootstrapping their businesses, should understand the basic concepts and key terms. As I’ve argued elsewhere, you should then be able to write out each of these, at any time, on a blank piece of paper – so that you have your important numbers at your fingertips. So here goes – with the caveat, these definitions are intended to provide you with a realistic image of where your business ACTUALLY is, rather than for compliance with accounting standards.

Revenue is the money customers pay you. Your revenue is when you sell a product (an app, a book or a sandwich) for $0.99, $1.99, or $4.99. If you sold 1,000 apps a month, your revenue that month would be $990 (1000*0.99) and for 1,000 sandwiches it would be $4,990. (Let us not worry that when you sell sandwiches you seem to make more money. Conceivably you could send millions or even billions of copies of your app – a little harder to do with sandwiches, or not if you are in India.) This is commonly referred to gross revenues for clarity.

Net revenue: In the case of selling sandwiches (directly), the entire $4.99 comes into your pocket. However, in the case of the app, only 70 per cent of the $0.99 makes it to you (after the app store aka your distributor, takes its 30 per cent off the top). So the reality is that out of those 1,000 apps you sell, you make only $693 (70 per cent*$0.99*1000). This is a significant difference to keep in mind – for when we plan with revenue, and not gross revenue, that 30 per cent difference (or $300 in this example) is likely to come and bite us. This is even more important in the case of marketplaces or services, where your business is essentially acting as a distributor – in which case you get to keep the 30 per cent (or 15 per cent or worse yet 7 per cent) of the revenue and pay your principal, which is the 70 per cent (or 85 or 93 per cent) of the revenues. Given the recent “hot” status of food-delivery companies (can anyone explain what’s tech about these) or any of the e-commerce companies, it’s important to not confuse gross revenues (or GMV – gross merchandise value as they call it) with net revenues. It is important to keep in mind that software or e-books have practically no incremental costs whether you sell 100, 1000, or millions of units. However, for each sandwich, we incur the costs of those slices of bread (or wraps) and all that you put in between them. This is termed as the cost of goods. So in conventional businesses gross revenues – cost of goods (channel costs too if they are non-zero) – is termed net revenue.

Gross margins (or profit) are essentially the difference between (gross) revenues and net revenue – often expressed as a percentage. This is a particularly critical measure as the profits of your business are constrained by this value. And yes Dorothy, profits are why you are in business. The higher your gross margins, the higher profit potential your business has. Often gross margins tend to operate in bands for specific industries or businesses and this is a good thing, for you to be able to measure where you are relative to others. In the above examples, for the app business, your gross margins are 70 per cent and in the case of the sandwich business, assuming the cost of goods for your fancy sandwich are $2.00, then your gross margin is 60 per cent ($4.999-$2.00)/($4.99). In these examples, if you sell your apps directly to users – on your website – your margins can increase to about 90 per cent, or use cheaper ingredients in your sandwiches (or leave out the cheese) you can increase margins. Such gross margin increases often translate directly to your bottom line. Again keep in mind, we make money in dollars and not in % dollars – so knowing both gross margins in % terms and absolute dollars is important. Do you know what your gross margins are and how you can increase them? Can you increase your gross margins to be so high that it can hurt your business? Yes, you can, but that’s for another day.

Operating expenses: Simply put, all the expenses you incur, regardless of whether you make a dollar of revenue or not, are your operating expenses. And these are only likely to grow. So the cost of paying your engineers or employees, your rent and utilities, the cost of maintaining a website (and that fancy domain name you bought), advertising and trade show expenses are all operating expenses. In an ideal world, you’d try to keep your operating expenses low – but not so low that you are not able to ship product or deliver services that generate the revenue. And depending on the nature of your business (for instance, if you do drug discovery or build semiconductors), your operating expenses are likely to be high – even without R&D costs. Operating expenses too, like gross margins, tend to operate in bands for specific industries, so you can benchmark yourself – allowing for where you are in the life cycle of your business (early, steady-state, etc.). By nature, operating expenses have some non-negotiables such as salary, rent, and utilities – you can decrease them only so much or not at all and others such as market or R&D expenses that are more amenable to adjusting.

Operating margins: This is your net revenue minus the operating expenses. This like the gross margin is a critical metric of the health of your business. When businesses talk about reaching operating profit, they are essentially saying that their operating margins are higher than zero. In your app business, if you are spending $4,000 a month and bringing in $4,500 in net revenues (70 per cent*$6500 in gross revenues) then you have achieved operating profit. Operating profit does not imply that your business is profitable (yet), but is capable of being so. For instance, in the example cited, this doesn’t take into account the one year and $50,000 you spent to develop your product and this run rate.

This operating margin is what the some bean counters love EBITDA – Earnings (profits) before Interest (on your loans), Taxes (yep those exists and you may have to pay them if you actually make a profit) and Depreciation and Amortization (let’s not even go there). It’s a somewhat independent measure of your business’ ability to make profits.

Net margins determines whether your business actually makes a profit – money you can put in the bank, or pay dividends with or better yet flow back into your business. So even though you may make real operating profits, if the interest on capital you’ve borrowed for instance is high, you may not have any net margins. This is why the cost of money or borrowing costs can make or break businesses that have high amounts of debt. Similarly, if you have to pay taxes (and you do if you make profits) this can drive your net margins down. At the end of the day, this is the ONE metric that will keep you alive and fund your growth. However, maximising this requires you to manage every one of the above – increasing gross revenues and gross margins allows more money to flow into the company. Decreasing or managing operating costs and financial costs ensures you maximise profit and can fund growth.

The table below summarises the terms discussed for a variety of different businesses

Can businesses run without making operating profit or positive EBIDTA? Amazon has been doing this for years and Flipkart and others are doing this even as we read this. This means someone (investors, founders, in rare instance public markets) is pouring capital and investment into the business – usually with the reasoning that you are capturing market share or leadership and therefore spending more than you are making. They are also operating under the assumption that one of these days you will make a profit and enough of it to justify the investment.

Meanwhile, for the rest of us (99%), knowing and keeping a good eye on these numbers would go a long way to ensure you stay alive and thrive.

(Disclaimer: The views and opinions expressed in this article are those of the author and do not necessarily reflect the views of YourStory.)