For companies at every stage of development, accurately measuring profitability is crucial to the creation of effective business practices and financial management. When you know how to calculate profitability and evaluate the profit for startups, no matter the sector, you can become a successful angel investor.
Businesses, accountants, and financial analysts use numerous metrics to measure profitability in different contexts—net income is probably the most well-known of these metrics.
From startups to blue chips, every company needs to keep a close eye on the bottom line. Net income reflects the amount of revenue that remains as profit after accounting for all expenses, debt, income streams, and taxes. However, while it gives a bird's eye view of profitability, sometimes the devil is in the details.
- For startups, it is especially important to measure and track profitability as the company grows.
- Employing several metrics—including net income, marginal revenue, and gross profit—is important when thinking about how to calculate profitability and ultimately a startup's success.
What Is the Best Way to Calculate Profitability for Startups?
At the most basic level, startups should assess profitability on an item-by-item basis. The goods or services, and in what quantities, that a company produces or delivers largely determines its revenue. Of course, without any revenue, there is unlikely to be any profit.
Marginal revenue is the amount of increased revenue generated by each additional item produced. If a company produces one more widget than it did the week before and sells it for $10, the marginal revenue for that widget is $10.
Maintaining healthy marginal revenue is crucial to ensuring a company's primary operations are not draining its finances unnecessarily. If the marginal revenue does not equal or exceed the marginal cost, there is little benefit gained by increasing output. Monitoring marginal revenue helps businesses of all sizes to ensure optimal production levels.
How to Calculate Profitability for Startups
However, there is a lot more to running a business than just adding up sales figures. Producing goods and services costs money before it makes money. Gross profit is a measure of profitability that accounts for the cost of creating products for sale and is calculated by subtracting the cost of goods sold (COGS) from total revenue. COGS includes all expenses directly associated with producing goods for sale, such as the cost of raw materials, labor to create or assemble products, shipping, and freight costs.
If a product generates a huge amount of revenue but costs almost as much to produce, there is little profit left over to invest in future growth. A startup with inefficient production will quickly find itself floundering.
At the next level, it is important to ensure day-to-day operations are not an unnecessary drain on cash flow. Operating profit measures the amount of revenue that remains after accounting for operational expenses, such as rent, utilities, wages, and insurance, in addition to COGS.
This metric informs business owners about the degree to which their potential profits are being eaten up by just keeping on the lights. If there is a large gap between gross profit and operating profit, it may be an indication that overhead expenses are too high. Startups can use this metric to inform their decisions about property location, business hours, and personnel changes.
For startups especially, calculating profitability at various levels is the best way to ensure optimal financial practices at every stage, paving the way for future growth.
Startups should use all profitability metrics to establish how and where they are making and losing money. From which products to sell, to how many people to employ, or how much debt to take on to fund future growth, assessing profitability at multiple levels enables business owners to make more informed decisions across the board to drive their businesses forward.