All businesses, from self-employed freelancers to Fortune 500 corporations, spend money. You might have to pay rent, buy inventory, pay employees, buy a desk lamp, or purchase heavy machinery—or even a new building. These expenses lower your company’s overall profit margin, so it’s critical to pay close attention to how you’re spending money.
Not all expenses are considered the same in the small business world. Some expenses, like rent and wages, are regular and recurring. Generally, these everyday purchases are considered operating expenses. Others, like the purchase of a vehicle or property, happen once and then last your business a long time. These are known as capital expenses.
The terminology can be misleading—if you drive it every day, isn’t a new car an operating expense? Probably not. Knowing the nuances of operating expenses and capital expenses is important for every small business owner.
Furthermore, differentiating between the 2 categories becomes paramount when preparing financial statements and filing your business taxes.
Operating Expenses
Operating expenses, often abbreviated to OPEX, are expenses incurred during the course of regular business—your operations, as it were. These include general and administrative expenses as well as the cost of goods sold (COGS). On your profit and loss statement, these expenses are recorded in the same time period they were actually incurred.The list of operating expenses is vast and ever-expanding—office supplies, equipment leases, travel, some types of taxes, utilities, and insurance are all considered operating expenses because you spend the money in order to conduct regular business. Wages are operating expenses, although they might be calculated into your COGS depending on your business.
Capital Expenses
Capital expenses, or CAPEX, are expenses that a business incurs that are expected to remain valuable beyond the current year. You might use collateral or take on debt to make a capital expenditure. The point of spending on CAPEX is that the expense now will help your business to expand over time—so a CAPEX should be seen as an investment.Property, equipment, and vehicles are common capital expenses. Expanding or adding value to an existing asset, like through a building expansion, could also be a CAPEX.
Instead of recording capital expenditure on your profit and loss statement, you list CAPEX as assets on your balance sheet.
Importantly, many capital expenses—like vehicles—depreciate in value over the usable lifespan of the asset. This depreciation over a fixed period of time, usually monthly, is recorded as an expense on your profit and loss statement. Overall depreciation is recorded on your balance sheet and subtracted from the value of the asset.
While many CAPEX are tangible entities, like buildings, some intangible purchases can be considered CAPEX, particularly patents.
Why Are OPEX and CAPEX Categorized Differently?
OPEX and CAPEX are considered different in accounting terms because operating expenses are necessary to your business’s day-to-day existence, while capital expenses are big, 1-time expenses that will add value to your company for years.Sometimes you can choose how you want to categorize an expense. If you buy a car outright, for example, it’s a CAPEX, but a lease for a vehicle is an OPEX.
OPEX vs. CAPEX on Financial Statements
Categorizing OPEX and CAPEX on your financial documentation is a strong reason to have an accountant overseeing your books. Additionally, most CAPEX will require input from other stakeholders in your business because of the size of the expense.“While OPEX are line items in the expense category on a cash flow statement, CAPEX are typically found under the heading ‘Investment in property, plant, or equipment,’” e-commerce company Shopify explains. “CAPEX usually require a sizable financial investment and, for that reason, often need the approval of the company’s board of directors or shareholders.”
Categorizing your various expenses on the proper profit and loss statements and balance sheets is essential for understanding the overall financial health of your company—and will better position you to receive funding.
OPEX vs. CAPEX During Tax Time
Not categorizing your expenses correctly with the Internal Revenue Service can result in penalties or even an audit. Even in less extreme cases, you can end up paying more in taxes if you aren’t separating your expenses as well as calculating the depreciation of your CAPEX.“Through depreciation you recover the cost of the asset over its useful life,” says Manny Davis of AllBusiness. “The IRS has strict requirements as to how many years an asset must be depreciated over. Since these assets cannot be expensed 100% in the tax year they are purchased, it will lead to a higher taxable income amount for the company in the given year and therefore higher taxes.”
The IRS allows some CAPEX to be expensed in total and at once through Section 179. Because of specific situations like this, you should consult with a tax professional about your business taxes—even if you don’t regularly hire an accountant. Utilizing bookkeeping software like Lendio's software also helps.
When opening a business, you have a lot of choices to make—including the structure of your business or the business entity. One of the most common types of businesses is known as an LLC, or limited liability company. In addition to being one of the easiest entities to form and maintain, it also offers legal and financial protection to its owners.
Keep reading to understand LLCs and why they are so popular.
What Does an LLC Mean?
A limited liability company works to protect business owners who want to separate their personal and professional assets. For example, if a sole proprietor gets sued, the lawsuit could cover that person’s income, home, car, and other personal assets.However, an LLC limits the liability to just the business assets. These assets include company profits, equipment, and inventory but do not extend to any personal assets outside the business.
An LLC is often used by business owners to protect themselves personally when they go into business.
How Can You Start an LLC?
To start an LLC, look up your state Chamber of Commerce and find the appropriate paperwork to complete an application. You will need to register your company under a name that is not currently used in that state. The application can be completed online in many districts and requires an application fee.What Does an LLC Cost?
The cost to form an LLC varies by state. Some states have affordable fees (Colorado charges $50 to get started), while others are more expensive (Massachusetts charges $500).Along with a startup fee, you will need to pay an annual fee to maintain the designation. These fees also vary widely depending on where you live. In Missouri, there is no annual fee, though business owners still need to submit annual reports. In Maryland, business owners need to pay $300 annually.
Look up your filing fees before you decide to become an LLC so you can budget for the costs.
What Is an Annual Report?
Most states require LLC owners to file annual reports that detail the operations of the business over the course of the year. The annual report covers information like the names and addresses of owners, the purpose of your business, and the number of shares of stock.These annual reports are typically due around the anniversary date of formation. You can often find annual report templates online.
When Should You Form an LLC?
While you can form an LLC at any time throughout the year, you may want to file at the start of the new year in January for easy tax purposes. That way, all of your future income is covered by the LLC.You don’t have to file your paperwork in January to form your LLC. Some states offer a “delayed effective date” up to 90 days out. This means you can work through your paperwork in October or November for an LLC launch date of January 1.
One of the key traits of an LLC is the separation between professional and personal accounts. If you plan to start a company, make sure you have a foundation of good bookkeeping to easily report your income and expenses. Use an app like Lendio's software, which offers free tools for small business owners. This can make establishing a business easier.
There are several methods to calculating depreciation, and business owners often want to find what works best for them—accuracy, convenience, tax-friendly. While the straight-line method might be easy, it doesn’t take into consideration how cared-for an asset is and how much work it performs. An item that is used constantly and rarely cared for won’t last as long (and will have a lower value) than a well-cared-for item or rarely-used asset.
The units of production depreciation method works to address this principle by tracking how much an item is used and using that to determine its value. Get to know this depreciation method better to see if it is right for you.
What Is the Units of Production Depreciation Method?
With the units of production depreciation method, an asset’s value is based on how much it is used—or the number of units it has produced. This method is often used for manufacturing equipment that wears down over time as it produces more products.
This depreciation method is popular in production-oriented industries because it can fluctuate based on machine demand for that year. For example, if a company works overtime to fill orders 1 year but then has downtime during another year, the depreciation amount is different because the assets were used less and therefore retained more of its useful life—value.
How to Calculate the Units of Production Depreciation Method
The units of production depreciation method is fairly straightforward to calculate. However, you will need to change the calculation annually based on the units an asset produced. You will also have to track how many units an asset produced to make sure your calculation is accurate.
Start by calculating the Units of Production Rate (UPR):
- UPR = (Cost of the Asset - Salvage Value)/ Total Units that Will Be Produced Over Its Life
Naturally, this calculation is an estimate. You can’t predict how long an asset will last (especially machinery) and the number of units it will produce—but you can make an educated guess based on the IRS value expectancy and the production rate of similar assets.
Once you have the UPR, multiply it by the number of actual units produced for that current year.
Let’s use the example of a baker who makes doughnuts with a specialized machine. This is what the formula might look like.
- (Machine Cost - Salvage Value)/Estimated Doughnuts Made Over Its Life x Doughnuts Made This Year
- ($25,000 - $500)/100,000 x 10,000
- $24,500/100,000 x 10,000
- 0.245 x 10,000
- $2,450
The depreciation for that year is $2,450. Now, if the baker makes more doughnuts the next year, the depreciation will be higher because there is more wear on the machine. Let’s say the baker made 15,000 doughnuts the following year. In this case, the depreciation would be:
- 0.245 x 15,000
- $3,675
Once you have the base formula for calculating units of production depreciation, you can estimate how much you lost in assets each year with relative ease.
Pros and Cons of this Method
The main drawback of the units of production method is that you can’t use it to calculate your tax deductions for the year. This means it can’t be your only depreciation method of choice. Some companies use the units of production method for their internal accounting (or to report to shareholders) and then opt for a different method for their taxes.
The units of production method also can’t be used for every piece of equipment. Not all assets can be tracked by what they produce. (You wouldn’t base the value of a computer on the number of emails it has sent or the total PowerPoint presentations it has created.) This means you could end up using multiple depreciation formulas for various assets internally, as well.
Finally, the units of production method isn’t predictable. You can’t easily estimate how your assets will change until you close your books and look at the number of units you produced. Your depreciation rates could fluctuate over time.
While all of these cons are significant, many manufacturers still prefer this method of accounting for depreciation because the value of an asset is directly tied to production. Teams can track an asset’s value over time to get a clearer idea of how long it should remain functional. This allows them to budget for replacements if an item is wearing out or schedule maintenance after a certain number of units is produced.
Learn More About Depreciation and Bookkeeping
As you set up your accounts for your small business, consider the various options at your disposal for calculating depreciation. Using the units of production method might be ideal if you work in manufacturing, but it likely isn’t the only model you should use.
A business entity refers to a type of business or the legal structure of that company. It does not refer to what that business does, the product or service it sells, or its industry.
As you develop your business, you may decide to change entity types depending on your plans for growth. Learn more about what a business entity means and how you can choose the right one below.
What Are the Different Business Entities?
A business entity structure varies by the size of the company (in some cases) and how it operates for tax purposes. The most used businesses entities include:- Sole Proprietorship: A business run by a single person without shareholders or employees.
- Partnership: A business run with 2 or more owners, where all owners manage the company and share the profits.
- Limited Liability Company (LLC): A company that offers liability protection to its owners. This entity is often used by individuals to differentiate their personal and professional accounts.
- Corporation: A professional entity that has shareholders, a board of directors, officers, and (often) employees. This designation tends to be the largest option.
What Are Business Entities Used For?
The Internal Revenue Service (IRS) differentiates business entities for tax purposes. They ensure that business owners pay the right amount of taxes or that some people don’t get double-taxed. For example, a sole proprietor running an LLC would only need to pay personal taxes because the LLC is a pass-through entity.Can You Change Your Business Entity?
In some cases, yes. As your business structure changes, you can adjust your status to become a different entity. For example, a sole proprietor can become a partnership if that individual finds someone to work with. They can also file for LLC status if they want additional protection.You can change your business entity status on your tax forms, but most states have a formal process to become an LLC or corporation. There are fees for forming LLCs and paperwork for some corporations. You will also have to submit annual reports to your state government if you operate an LLC or a corporation.
Are Some Business Entities Better Than Others?
The status that you choose for your business is based on what is right for you at the time. One status is not better than the other when reviewed as a whole. However, there will likely be 1 or 2 entity options that stand out as you decide which to choose. When deciding on the best entity for your business, consider your current size and structure, as well as your growth plans and tax strategy.Knowing your options for the different business entities can help you launch your company with the right status for your tax needs. You can file correctly and potentially save money. As you launch your business, make sure you have organized bookkeeping and an accounting plan for your taxes. Consider using a free service like Lendio's software to keep your records in order. Our tools are here to help you.
An invoice is a document sent from a business to a customer indicating products sold or services executed (or agreed upon).
The document will often include client and business information such as logos, addresses, and contact details in addition to transactional information like the type of products or services, quantities, and scope. The invoice is essentially a bill, and it will often include payment terms, timelines, and other information.
Keep reading to learn more about how to pay an invoice.
Receiving Invoices From Businesses
Every business handles invoicing differently. Some utilize invoicing software to streamline the management and tracking of paid and outstanding invoices, while others prefer creating and mailing an invoice by hand. Some businesses invoice with strict payment terms, while others provide more flexible timelines and payment options.
Simply put, you can receive many different types of invoices through various methods. While the invoice itself may be unique, there are only 2 channels to receive an invoice.
- Online: More recently, businesses are choosing to move their invoicing online for simplicity and cost savings. The most common way to receive an online invoice is via email. However, you’ll likely be directed to an online portal to pay that invoice. Many of these client portals will allow you to review and manage outstanding and paid invoices
- Offline: While online invoicing solutions are becoming more and more popular, some small businesses still prefer tangible invoices. You may receive invoices from local businesses by mail or in-person after a project is completed.
When Should You Pay an Invoice?
Paying bills on time is an important step in maintaining good relationships with businesses and vendors. If you’re frequently late on payments, the business may decide to charge you more—or to drop you entirely. If you operate in the business-to-business (B2B) space, losing a good vendor can cause bottlenecks and quality control issues throughout your business. So always pay your invoices on time.
Payment terms are often discussed before work is started and will often be outlined within the invoice. For many industries—especially B2B—it’s possible to have payment timeframes that extend weeks or even months after the work is completed or products delivered. You may also be able to negotiate discounts for up-front or early payments if the business struggles with cash flow or delinquent payments.
Most invoices will include phrasing like “payment date” or “net-payment terms” that indicates the deadline for paying an invoice. Net-payment terms are often used to express a timeframe or window to pay an invoice within. For example, if you have an invoice with net-15 terms, it means you have 15 days from the time you received that invoice to pay the balance.
If you received an invoice with no payment terms outlined, the typical timeframe of 30 days should be assumed.
How to Pay an Invoice Online
The physical process for paying an invoice online will vary based on the invoicing or payment processing software the business uses. Typically, it will flow like this:
- Open the email with the outstanding invoice.
- Look for a button that directs you to “Review and Pay Invoice.”
- Confirm that all the information is accurate.
- Find the button or area on the page that directs you to pay.
- Input your credit card information or complete other payment method requirements.
- Confirm that the payment amount matches the invoice and what you agreed upon.
- Submit the payment and receive the receipt.
Paying invoices online is usually a seamless process. Best of all, most businesses allow for flexible payment methods. Some of the common ways to pay an invoice online include:
- Credit card payment: The most common way to pay an invoice online is by credit card. While most businesses will allow any type of credit card, you’ll want to confirm beforehand—some businesses do not accept credit cards like American Express or Discover because of their increased fees to companies.
- Bank transfer (ACH): Another popular method for paying an invoice online is to pull it directly from your bank account via ACH. If you can afford to pay with ACH, you can often use this fact to negotiate lower rates with businesses. ACH payments can save a business money on transaction fees, which can be quite expensive—especially on large invoices.
- PayPal payments: PayPal is another common way to pay invoices online and simply involves signing into your PayPal account within the payment processing step. To pay an invoice with PayPal, you’ll need to have an active and funded PayPal account or have it connected to your bank account.
How to Pay an Invoice Offline
If you received an invoice and are looking to pay it without using an online option, then you’re limited to a few methods. While not the most convenient, safe, or fastest way to pay invoices, offline payments usually include:
- Paying in person: You can often pay invoices in person—with COVID-19 restrictions, you’ll want to confirm this first. Typically, you can use a credit card, check, or debit card to pay a bill directly at the business.
- Paying over the phone: Many businesses will also accept payments over the phone, but this is not the most secure way to pay an invoice. The business will collect your credit card information over the phone and pay the bill manually.
- Paying by mail: You may also be able to write a check and pay your invoice through the mail. Again, this is not the safest or fastest way to pay a bill—and the customer may experience delays, which could cause your payment to arrive after the due date.
Small business owners have a lot on their plates. Between scaling operations and maintaining quality control to balancing employee morale with production goals, it may seem like a wave of chaos more often than not.
When it comes to a seemingly small task like record keeping, it’s often easy to brush it off. However, businesses need to not just pay attention to their records—they also need to save, store, and organize them in case of an audit, dispute, or other possible issues in the future.
How long should you keep your business records? Is there a statute of limitations on retaining them?
What Types of Business Records Should You Keep?
Before diving into how long to keep records, it’s good to know which types of business records are worth keeping in the first place. Businesses have complete control over how they keep records: some may choose to use physical journals and ledgers, while others have migrated to digital bookkeeping.
Regardless of your record-keeping method, your transactions will typically involve some sort of supporting documentation such as a bill, invoice, or receipt. Collecting, organizing, and managing these supporting business documents is crucial because they may be needed to substantiate your book entries and tax returns.
Below are some of the common types of business records to keep (including the possible format of the record):
- Gross receipts: Documents verifying the revenue you earned from your business (sales receipts, invoices, 1099 forms, or bank deposit slips)
- COGS receipts: Records supporting purchases made by your business directly related to products sold or services rendered to customers (canceled checks, electronic transfer receipts, credit card statements, or invoices)
- Expenses: Documents for other non-COGS expenses related to running your business (credit card statements, cash register tape receipts, or invoices)
- Assets: Records of assets for purchases, depreciation, and gains or losses on sold assets (purchase receipt with price, Section 179 deductions, selling price, or real estate statements)
- Employment documents: Specific records you need to keep related to employees (W4s, W9s, employment tax documents, reported tips, or copies of filed returns)
- Business documents: Other business-related documents worth saving beyond accounting records (Articles of Incorporation, business licenses, or board meeting notes)
- Legal documents: Legal records to defend claims and protect your trademarks or IP (insurance policies, patents, or trademarks)
Note: In some instances, you may need to provide a combination of documents to substantiate any claims.
Why Should You Keep Business Records?
Small business owners would be wise to develop excellent bookkeeping habits. Managing your records—and the supporting documents of those records—efficiently will protect you against any IRS audit, which can happen within a 6-year window. It can also provide you with valuable insight that can help you to run a more successful company.
Good record keeping can help small businesses to:
- Track the company’s progress
- Streamline its financial reporting
- Identify issues and opportunities
- Optimize tax deductions
- Validate and support tax returns
- Protect the company in the case of an audit
How Long Should You Retain Business Documents and Records?
Maintaining accurate books and managing supporting business records is an ongoing process that will continue across your business’s lifespan. However, you don’t have to inundate your office with file cabinets and overwhelm your servers with decades of files. The IRS has set some standard retention guidelines for tax records as well as general rules for how long to keep other business records, too.
"Generally, I recommend businesses retain all important documents for a minimum of 7 years,” says Karl Swan, tax manager at Rivero, Gordimer & Company. “However, business documents like Articles of Incorporation, copyright and trademark registrations, patents, and other important records should be safely stored permanently. Before destroying any business document, consult your chief financial officer or a 3rd-party financial professional to make sure its destruction is compliant with federal and state laws and regulation."
Below are some of the records and timelines for retaining those records as advised by the IRS.
- Financial records: The rule of thumb for anything finances-related (receipts, invoices, credit card statements, canceled checks, etc.) is to keep those records for at least 7 years. The IRS can audit your business within the previous 6 years, so if you keep these records safe for 7 or more years, you will have them ready if you’re ever audited.
- Employment tax records: You’ll want to retain all your employee tax records (1099s, W9s, W2s, etc.) for a minimum of 4 years.
- Business asset returns: It’s recommended that you hold onto all documents relating to a business asset until a year after the asset is disposed of or sold.
- Human resources files: There are different recommendations based on the scenario for keeping HR documents. For any active or terminated employee, you should keep files stored for at least 7 years after their termination. For job applicants who were not hired, store their records for at least 3 years. For onsite injuries, you’ll want to retain related records for 7–10 years.
- Important business documents: You should always save important business documents like your Articles of Incorporation, patent filings, legal correspondence, by-laws, and other legacy business documents.
Keeping clean and accurate books is a crucial step in running a successful small business.
Cash flow is a critical metric every small business needs to pay attention to. It reveals your company’s financial health in the immediate present by comparing money flowing in and expenses flowing out. While knowing your revenue is obviously important, cash flow shows you how much actual money is moving into and out of your bank accounts.
With some math and some informed conjecture, you can chart the expected cash flow of your business for the future.
Why Is Cash Flow Projection Important?
What if you have to make payroll before receiving funds from a big invoice? This situation is a cash flow emergency—and a dangerous one at that—but you might not foresee it by just looking at income statements and expense reports. A cash flow statement can help you understand the present situation.Cash flow projections, then, predict your cash flow in the future. A cash flow forecast can help you circumvent dreaded cash crunches, which is when your business needs to spend money but there isn’t enough cash on hand to cover the expense. Cash crunches are damaging to any business, and they can be ruinous for young or very small businesses.
Fortunately, with some preparations, you can project your future cash flow and determine how to focus on creating cash flow.
Cash Flow Forecast vs. Projection
The terms cash flow forecast and cash flow projection are used interchangeably by most small business owners and banks, but some consider them to be slightly different documents. In this latter definition, a cash flow forecast predicts your cash flow based on the most likely prospects of your company’s future, while a projection predicts cash flow based on alternative, hypothetical future situations, like an economic recession or a boom in customers due to a great marketing campaign.No matter what you call your cash flow documents, you should prepare several based on different potential futures. It is a good idea to prepare one cash flow projection based on your present business, as well as a best-case cash flow projection and a worst-case cash flow projection.
How Do You Calculate Cash Flow Projections?
You must pay attention to 2 main elements when creating a cash flow forecast: accounts receivable and accounts payable.Accounts receivables includes money that is expected to flow into your business, such as sales and payments from client invoices. Grants, rebates, loans, and funding are all considered receivables, too.
Accounts payable is the other side of the equation. Payables include anything your business spends money on: your salary, payroll, inventory, overhead, rent, taxes, and all expenses.
A cash flow statement compares accounts receivables to accounts payable. A cash flow projection predicts your cash flow over time.
To create a cash flow projection, it can be wise to start with the past. Look at 12 months ago and record how much cash was in your bank account—this amount is your starting balance in this example. Break down the past 12 months in terms of receivables and payables. Try to categorize your income and expenses as much as possible to get a better sense of where your money is coming from and what you are spending it on.
For the first month, subtract the total amount of payables from your total receivables. This calculation gives you your cash flow for the month. If it is negative, subtract it from your starting balance. If it is positive, add it to your starting balance. This new balance is the starting balance for the following month.
Repeat these calculations for the entire 12-month span and you’ll have a cash flow chart for your business.
The Small Business Administration has several great templates you can use to make this easier, including a cash flow projection template.
To predict into the future, you can sometimes reuse a lot of the data from the previous 12 months if your business stays stable in that regard. If you know of the specific revenues, funding, and costs that your business will incur in the future, you can use that data, although you should include some contingency spending.
If you are less sure about the future, start with what you know, like rent payments and clients who pay you a specified amount on a repeating basis. Then make educated guesses about what your cash inflows and outflows will be over the next few months. Here is where it makes sense to create several different cash flow projections for your status quo, best-case, and worst-case scenarios.
The time extent of your predictions is up to you, but you should think about your available data. If your company is well-established, you can create projections for many years into the future. If your company is very young, though, it might be more accurate to think in terms of a few months to a year out.
What Is a Cash Flow Projection Example?
Say your company starts the year with $80,000 in its bank account. This amount is your company’s starting balance for the year. During the month of January, you think you’ll make $5,000 in cash sales and collect outstanding invoices totaling another $2,000. You will also receive a business loan of $10,000 from a lender. These are all accounts receivable, and your accounts receivable total is $17,000. Between all your expenses for rent, inventory, and your salary, your accounts payable for January is expected to be $15,000. Your cash flow projection for January is $2,000 and you expect to end the month with $82,000 in your bank account.Is Positive Cash Flow More Important Than Profit?
Positive cash flow and profit are different but interwoven elements of a company’s success. Positive cash flow can be more important in the moment because it helps you avoid cash crunches. Over time, though, you want to earn a profit if you want to expand.You should think about and create forecasts for both profit and cash flow.
How much money are you making?
This is a common and succinct question small business owners often receive, however crass it might seem. The question can feel like a dagger to the heart or a point of pride, depending on how you perceive your business is faring financially.
But how do you know how your business is doing? How do you know if your business is making money or not?
There are 2 main ways to understand the cash coming into your coffers: revenue and profit.
Revenue and profit are 2 systems of defining the money your business is making. Revenue is the top line, and profit is the bottom line.
Let’s explain these concepts, how they interact, and what they mean for your business.
What Is Revenue?
“Revenue” is synonymous with “sales” on many financial documents, and for good reason. Revenue is all the money your business brings in through its operations. For most small businesses, this means money earned from selling goods or services.Revenue is the top line because it is all the money your company makes before subtracting any costs.
For many small businesses, especially new ones, revenue is critical. If your revenue is increasing over time, you know there is a demand for your product or services.
However, judging your business’ financial health based on revenue is a bad practice because revenue is too broad of a metric.
For example, suppose an auto dealership decided to severely undercut its competitors by selling new cars for less than it paid for them from the automakers. Revenue would likely skyrocket as consumers discover that its cars are much cheaper than anywhere else. However, the dealership would probably be in deep financial trouble because it would be losing money with every sale.
Still, there are no one-size-fits-all answers about whether revenue or profit should be your focus. In the above example, the dealership might decide the good PR gleaned from the happy customers will be worth more in future sales than the money lost during this price-cutting move.
What Is Profit?
Profit is the money you receive after subtracting expenses from your revenue. Analysts will also refer to profit as “income” or “earnings.”Revenue is your company’s top line. Then, in your ledger, you subtract various expenses to receive your profit—your bottom line.
Profit usually refers to a positive bottom line. You are then “in the black”—a reference to how accountants commonly color-code their books. If your expenses are greater than your revenues, your profit is negative, although you would probably refer to this figure as a “loss.” Your business would then be “in the red.”
What expenses do you subtract to figure out your profit? There are several methods of computing this number. Gross profit is when you subtract the cost of goods sold (COGS) from your revenue. COGS are the direct expenses associated with each good or service you sell (i.e., the cost of manufacturing or acquiring your goods). This does not include indirect costs, such as rent for your office.
Operating profit subtracts overhead expenses like office rent or marketing from revenue along with COGS. Because of this, it might be a more holistic approach to analyzing your financial situation. There are even more ways to define your profit, like pre-tax profit or net profit.
Your profit margin is how much profit (or loss) you earn (or lose) with each sale; profit margin displays how your profit increases off of your revenue. To determine profit margin, take a version of profit (like gross profit or operating profit) and divide it by your revenue. This will give you the decimal expression of your profit margin percentage.
Is Profit More Important Than Revenue?
From an extremely generic standpoint, profit is more important than revenue for small businesses. However, there are huge exceptions to this rule, including whole industries.“When it comes to investors, there’s a divide,” analyst Andrew Marder of software platform Capterra explains. “In the tech startup world, revenue is often seen as the end-all, be-all of finance. Venture capitalists look for companies that can ramp up revenue regardless of cost, hoping to figure that bit out later on down the line.”
Famously, Amazon, Uber, Zillow, and many other unicorns that define our modern life took decades to turn a profit—some still have yet to be out of the red.
But the circumstances are vastly different between an app startup and a small business in retail, hospitality, or professional services. In most cases, profit is a much more accurate indicator of a company’s financial health.
“In the world of more classic, Warren Buffett-style investing, revenue is almost meaningless,” Marder continued. “These investors—which may also include your business banker—want to see money making it all the way to the bottom of the earnings statement.”
The safest position is to pay continual attention to both revenue and profit—you can’t have any profit without revenue, after all, but you probably want to be spending less money than you are bringing in through sales.
How Do You Gauge Your Business’s Financial Health?
While revenue and profit are important components for diagnosing your company’s overall viability, more information is needed. The professional help of an accountant can be extremely useful for this.“Looking at your bank account is a bad way to manage your business,” suggests CPA Shabir Ladha. “Many entrepreneurs do it because that’s the only piece of information they have. Having the right bookkeeping or the right information is vital for business health.”
When thinking about your company’s financial wellbeing, you also need to consider expenses, cash flow, and less tangible factors like branding or public perception.
How Do You Increase Profits and Revenue?
From a mathematical perspective, you increase revenue by making more sales. You increase profit by increasing revenue, decreasing expenses, or both.Easier said than done! But that is the task of running a small business. With planning and research, you can best chart a path to thrive financially.
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