How Much Profit Should You Target?

How Much Profit Should You Target?

Many business owners underestimate the importance of planning- specifically having a detailed, written budget and consciously choosing their level of profitability.

An important component of that planning is how to decide what your business’ target level of profitability should be. And the answer is not “as much as possible”. Obviously you want as much profit as possible… but what level is acceptable and how do you determine it? Furthermore, why is it important?

Recently this topic came up with a client and we were discussing the budget process for the upcoming year. Like many small companies, they had never created a formal budget before (despite 10+ years in business). In the course of the discussion, he asked:

“How do I know how much profit to shoot for?”

That’s a good question. If we cornered most small-business owners and asked this question, we’d get mostly vague answers or “I don’t know”. Unless the company is owned by a private equity group, there is probably very little thought given to this.

Why would a private equity group be more likely to have a tangible answer?

Because a private equity group does not own a business in order to make the best product, or because they have a passion for their service, or because they have unique expertise in a certain area. They own a business because it is an investment. And generally, they have specific targets for how their investments should perform.

And so should you.

If you study Warren Buffett at all, you’ll learn that one of the key measures he uses to evaluate investments is Return on Equity (ROE). And any business owner can apply similar evaluation measures to his or her own business.

Return on Equity is Profit divided by Equity (or average equity) expressed as a percentage. For example:

ABC Manufacturing earned $30,000 in profit last year. Beginning equity was $500,000; ending equity was $530,000. Therefore ABC’s Return on Equity is 5.8% ($30 divided by $515 (($500+530)/2)).

5.8% ROE is not exactly “Buffett Material”. A rule of thumb would be to target 15% ROE- but each company has unique circumstances that may influence this “hurdle” rate (e.g., owners salary level relative to the market, other benefits and perks, etc.).

The key is to evaluate your business as if it were an investment- similar to a stock investment. And base your targets on “acceptable” levels return on the investment (equity) you have in your company.

Few business owners actually know what their ROE is, and fewer yet have even thought about evaluating their business in this fashion.

Since your business is an investment, it should be evaluated as an investment- similar to any other stock investment you might have. And you should base your targets on “acceptable” levels of return (profit) on the investment (equity) you have in your company.

In the short run, this is important for both obvious and non-obvious reasons. Obviously we want to generate as much profit and cash as possible, and having a target means we’re setting expectations and (hopefully) accountability. Less obviously, when we evaluate financial performance using the ROE metric (among others), we can calculate the relative performance of the business compared with other alternative investments to ensure we’re deploying resources in a fashion that generates the highest return.

As an example, if your business generates $200K in profit on $1M in revenue, you may be happy with that 20% profit. But what is you have $5M in equity? The ROW is a relatively puny 4%. You’re probably better off redeploying your $5M in a less risky investment and generating a higher return. At some points in history- even recent history- you could get 6% in a bank CD (nearly risk-free). Looking at that $200K in this light might change your level of satisfaction.

In the long term, it’s important to monitor ROE if you hope to eventually sell the business and cash out. A buyer will pay more for a company that has consistently generated a high ROE. It shows that the owners are deploying resources in an efficient and profitable manner.

Of course there are other metrics to consider, but ROE should become part of your performance evaluation metrics and used as a litmus test for how you’re deploying resources (capital).

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