Tag Archives | net income

Maximizing Your Bottom Line In 3 Simple Steps

Sales are great, but wouldn’t they be better if you were actually able to reap the rewards? Many CEOs that were not trained with an accounting/finance background struggle to understand profitability. They think that if sales are great, then the business is great. But when sales increase, inventory and overhead increases. Productivity also decreases – due to exhaustion or overwork. Collections lapse because there isn’t a “pressure” to collect. And unfortunately, that is when companies suffer the most. Sales start to decline, but they don’t change their habits. In this Wiki, you will learn how everything below sales on your income statement is critical to your company’s success and how you should be maximizing your bottom line – net income – at any stage of your company’s life cycle. Let’s look at how maximizing your bottom line in 3 simple steps can happen.

What is the Bottom Line?

First, what is the bottom line we are referring to? It is the net income on your income statement or P&L statement. This is what you have left after all the costs of goods sold, administrative expenses, and overhead have been subtracted from revenue. We look at this number carefully because that is how much you are able to put into retained earnings or reinvest back into your company. In addition, the amount can be used to issue dividends to their shareholders. Maximizing your bottom line should be an integral part of your company’s processes.

Profitability starts at the top of the income statement. If your prices are not set to create profitable environment, then you will be not able to maximize the bottom line. Learn how to price for profit using our Pricing for Profit Inspection Guide.

Maximizing Your Bottom Line In 4 Simple Steps

There a are several ways to maximize your bottom line – some more extensive and time consuming than other. But there are 3 areas to focus on to maximize your bottom line – including productivity, overhead, and collections.

1. Productivity is Key

It’s been a common theme among business blogs and news sources (Entrepreneur, Forbes, WSJ, etc.) to improve productivity. Why? Because productivity is key in maximizing your bottom line. But what really happens when you improve productivity? You have more supply, decrease the cost to produce 1 unit, and increase sales. It speeds up your operations so that you can fulfill more orders for quickly.

2. Manage Overhead

Great revenues have very little meaning if your overhead costs are not properly managed. Look deeper into your overhead expenses and find out if there are any costs you can reduce or completely remove. The problem is often more complex than large expense accounts on the P&L. You must interact with various departments to think critically and solve problems. Ensure that every single overhead cost is necessary to provide the desired service levels. Maximum controllability over costs leads to higher profits for the company to reap.

3. Collect Quicker

Collections are an important part of business. If a company sells $10,000 worth of product but only collects $3,000, then their cash is tied up in inventory, etc. As a result, they experience a cash crunch. We have worked with clients who were in the same situation and they neglected to ever collect the outstanding balance. Their bottom line suffered, but they didn’t think to look at their collections process. There are two metrics that you can look at to monitor collections and use to collect quicker.

The first metric is DSO. Do you know your Days Sales Outstanding (DSO)? This is a great measurement to know where you are currently and how by making slight adjustments, you can increase profitability. Use the following formula to calculate DSO.

 DSO = (Accounts Receivable / Total Credit Sales) * 365

The second metric to look at is Collections Effectiveness Index (CEI). This is a slightly more accurate representation of the time it takes to collect receivables than DSO. Because CEI can be calculated more frequently than DSO, it can be a key performance indicator (KPI) that you track in your company. If the CEI percentage decreases one month, then leadership are alerted that something is going on. The goal here is to be at 100%.

CEI = [(Beginning Receivables + Monthly Credit Sales – Ending Total Receivables) ÷ (Beginning Receivables + Monthly Credit Sales – Ending Current Receivables)] * 100

Another method to collect quicker is to tie receivables to the sales person’s commission. This will not only encourage your sales team to be part of the collections process, but it will help keep your company cash positive.

Effective Strategies for Improving Profitability

While we’ve been focused on maximizing your bottom line as your current financials stand, we also wanted to share some effective strategies for improving profitability.

Price for Profit

Are your prices leading to a satisfying net income?  If not, then these are some questions you can inquire:

  • Are additional costs being reflected on the price?
  • Are you using Margin vs Markup interchangeably?
  • Is your overhead being covered?

The solution might be simple: Adjust your price!

Learn how to price for profit using our Pricing for Profit Inspection Guide. This whitepaper will help you identify if you have a pricing problems and how to fix it.

Create Standard Operating Procedures (SOP)

Also, create Standard Operating Procedures (SOP). SOPs are step by step instructions written by a company to assist employees in completing routine procedures. They are necessary in a company to ensure operations run smoothly. The better your company’s SOPs are, the more efficient it will run. Create operating procedures that are simple, easy to read, and most importantly make them lead to a purpose.

Focus on Profitable Customers

Identifying profitable customers is instrumental to a company’s success. Once you completely identify your most profitable group of customers, focus your attention on them. Use your marketing funds primarily on you most profitable customers. A customer outside of that target market is still a viable customer, but they just shouldn’t receive as much marketing attention since they are not their primary and most profitable customer segment.

When maximizing your bottom line, start with your prices and pricing process. Access the free Pricing for Profit Inspection Guide to learn how to price profitably.

maximizing your bottom line

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What is Cash Flow?

See also:
Free Cash Flow Definition
How Growth Affects Cash Flow
Why Use a 13-Week Cash Flow Report as a Management Tool?
Why You Need to Have a 13-Week Cash Flow Report

What is Cash Flow?

Cash flow is a term describing the money into and out of a business. This includes all transactions that transfer cash. Furthermore, the business’s sources of cash are separated into three areas in the company’s cash flow statements. Some of the different categories for money spent or earned to fit into the following:

Cash flow in vital to your business. It is the blood or oxygen for your company. Without it, there is no company.

What is Net Income?

Net income is a measure of revenue after subtracting all expenses. This means you take the total revenue for a period and subtract cost of goods/services as well as overhead. This gives a rough idea of whether a business made ‘money’ during the period. However, net income is not a good way to determine the cash usage in a business.

Key Differences Between Cash Flow & Net Income

Some of the key differences between cash flow and net income include the following:

  1. A business can be profitable and go out of business from lack of cash.
  2. A business can have cash flow but remain unprofitable.
  3. Cash flow is reflected on the cash flow statement and not the income statement or balance sheet.
  4. Analyzing cash flow is a way of planning for future cash needs.
  5. Investors can tell where the cash comes from and where it goes from statement of cash flows.
  6. Loans show up as cash on an income statement; Loans are shown as positive financing activities in the statement of cash flows.
  7. Watching cash flow helps notify a business of cash shortages and shows when to borrow money to keep operations going.

Click here to read more about Cash Flow vs Net Income.

What is Cash Flow?

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Impact of FIT on Sustainable Growth Rate

The Institute of Fiscal Studies authored a study on tax systems in the UK called “Tax by Design: Mirrlees Review.” They concluded that “in the long-run, the tax system should be judged in part on its impact on the sustainable growth rate of the economy… viewing efficiency in a dynamic as well as static sense.” As we enter into tax season, you as the financial leader of your company should understand the impact of FIT on sustainable growth rate in your company.

What is Sustainable Growth Rate?

Sustainable Growth Rate (SGR) is the maximum amount of growth that an organization can sustain without increasing their financial leverage. It commonly suggests the percentage (%) growth in revenue that an organization can sustain with its current profit margin, earnings retention rate, leverage, and asset turnover.

Sustainable Growth Rate (SGR) = (1-d) x ROE

Dividend Payout Ratio (d) =  dividends / earnings

Return on Equity (ROE) = net income / shareholders’ equity

Even though there are numerous methods to increase your sustainable growth rate (such as increase the profit margin, asset turnover ratio, assets to equity ratio, or retention rate), the federal income tax can blindside you if you don’t prepare for it. FIT is unavoidable.

There are several economic theories concerning FIT, including the Laffer Curve and Reaganomics, that can be utilized to understand the impact of FIT on your SGR.

Laffer Curveimpact on sustainable growth rate

The Laffer Curve, created by Arthur Laffer, demonstrates the relationship between governmental tax revenue and tax rates. It important to understand this curve because at any given point on the curve, the amount of financial leverage you can supply to spur growth will differ.

If the tax rate is at Point A, then the government isn’t necessarily pleased by leaving your company with more dropping to the bottom line. This level of tax rates allows for your company to be more productive. Not only will you be able to breathe easier knowing you don’t owe the government so much, but your employees will be incentivized to work harder. They now know that their hard-earned money will land in their pockets. But having low tax rates isn’t always ideal. This is because your employees don’t have to necessarily work more to attain the “same” amount of “success” as they would at the Equilibrium Point.

If the federal income tax rate is at Point B, then both your company and your employees will question why should work be done. Since the government will be taking away 80-95% of revenue or income, the motivation to work will decrease significantly. At the point, your sustainable growth rate will be affected dramatically because the amount of financial leverage you have to spur growth is minimal. This point is typically seen in dictatorial economies.

Like in all things, there is an Equilibrium Point. This point allows for the government to make money as well as your company. Productivity remains high, allowing you more flexibility to provide growth in the company.

Although you cannot control the tax rate that the government has set, know how it impacts your company. One way to do this is by understanding the history of income tax rates.

Reaganomics

impact on sustainable growth rate

President Ronald Reagan called for widespread tax cuts during his presidential election in 1980. Within this economic plan, we saw four major factors:

  • deregulation of domestic markets
  • increased military spending
  • widespread tax cuts
  • decreased personal spending

The hope in implementing this plan was to reduce company’s expenses (primarily from tax expenses) to improve the economy as a whole. But as we saw with the Laffer Curve, there is a point when federal income taxes could be too low to improve the sustainable growth rate of a company.

Impact of FIT on Sustainable Growth Rate

In any company, cash is king. One of the major cash expenses that every company has is federal income taxes. Any tax strategy used to drive financial performance should not be considered as the end-all-be-all. The FIT reduces the amount of cash or financial leverage you have to increase your sustainable growth rate.

However, there are mechanisms or key performance indicators (KPIs) that you can utilize to focus on increasing your internal financial leverage. FIT is something that you cannot avoid. It will affect your sustainable growth rate. But by using a few indicators to measure profitability, etc, you’ll be better able to increase your SGR.

(NOTE: Want to start measuring your company’s KPIs today? Check out our KPI Discovery Cheatsheet!)

When calculating your sustainable growth rate, it’s important to recognize that any positive rate can allow for growth. It’s imperative to calculate FIT when you’re expecting or desiring growth.

Sustainable Growth Rate (SGR) = (1-d) x ROE

ROE (net income / shareholders’ equity) should have your FIT factored in. It’s easy to forget this important step until you find your wanting to utilize your internal financial leverage and you lost 35% of profit, severely reducing the financial leverage that you thought you had. Know the impact that the federal income tax has on your sustainable growth rate.

If you want to track your sustainable growth rate, then download your KPI Discovery Cheatsheet today.

impact of FIT on sustainable growth rate

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Cash Flow vs Net Income

See Also:
Operating Income (EBIT)
Free Cash Flow Analysis

Cash Flow vs Net Income

What is Cash Flow?

Cash flow is the blood of a business. It is the measure of what cash is coming in and what is leaving. Cash flow is a more accurate measure of whether a company has enough capital to sustain itself. For example, a company can be extremely profitable and still go out of business due to poor cash flow.

In planning a new business, cash flow is still a very important concept to focus on. Different services and habits affect cash flow. For example, a company’s payment terms greatly affect the amount of cash flowing in and out of a business. If it gives terms that are long, the business could have trouble meeting its other financial obligations. If the terms are short, it can give the business terrific cash flow.

The difference in length of terms comes down to the sizes of accounts receivable and inventory. If a business’s accounts receivable is high relative to its revenue, it is a sign of cash flow problems. Furthermore, if a company has a large inventory account, it can also be a sign of poor cash flow. A large inventory could show a purchasing problem that siphons cash faster than it is needed. Either way, if a business has too much tied up in inventory, it causes cash flow problems. The balance sheet and income statement might show a profit, but cash flow shows whether a business can sustain itself.


Download The 25 Ways to Improve Cash Flow


Cash Flow Statements

Cash flow statements are broken down into three areas. The areas are operating activities, investing activities, and financing activities. The idea behind separating these sources of cash is to get a better idea of where the cash is coming from. A detailed cash flow statement shows what amount came from loans, products/services, and investments. This can be very useful to investors and lenders.

What is Net Income?

Net income is calculated by subtracting total expenses from revenue. This is the ‘profit’ that most people refer to. Within the total expenses to be subtracted from revenue, overhead and cost of goods/services are both included. This means that net income is the measure of whether a company actually made money during a period. Due to accrual accounting, net profit does not automatically mean a business has cash. However, net income is efficient at tracking business done within a period. This makes net income a better estimate of profitability than cash flow.

For more tips on how to manage your cash flow, click here to access our 25 Ways to Improve Cash Flow whitepaper.

Cash Flow vs Net Income
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Return On Equity Example

Return On Equity Example

A return on equity example – Melanie, after seeing success in her corporate career, has left the comfortable life to become an angel investor. She has worked diligently to select companies and their managers, hold these managers accountable to their promises, provide advice and mentoring, and lead her partners to capitalization while minimizing risk. At this stage, Melanie is ready to receive her pay-out. As a result, Melanie wants to know her Return on Equity ratio for one of her client companies.

So, Melanie begins by finding the net income and average shareholder’s equity for the venture. Looking back to her records, Melanie has invested $20,000 in the business. Her net income from it is $6,000 per year. Performing her return on equity analysis yields the following results:

Return on equity: $6,000 / $20,000 =30%

Melanie is happy with her results. Purposefully starting small, she has built the experience and confidence to be successful. She can now move on to bigger and better deals.

Don’t leave any value on the table! Download the Top 10 Destroyers of Value whitepaper.

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See Also:

Return on Common Equity (ROCE)
Return on Equity (ROE)

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Return on Equity Analysis

See Also:
Financial Ratios
Return on Asset
Required Rate of Return
Return on Invested Capital (ROIC)
Debt to Equity Ratio
Return on Common Equity (ROCE)
What The CEO Wants You to Know How Your Company Really Works

Return on Equity Analysis

Defined also as return on net worth (RONW), return on equity reveals how much profit a company earned in comparison to the money a shareholder has invested.

Return on Equity Explanation

This term is explained as a measure of how well a company uses investment dollars to generate profits. Return on equity is more important to a shareholder than return on investment (ROI) because it tells investors how effectively their capital is being reinvested. Therefore, a company with high return on equity is more successful to generate cash internally. Investors are always looking for companies with high and growing returns on equity. However, not all high ROE companies make good investments. The better benchmark is to compare a company’s return on equity with its industry average. Generally, the higher the ratio, the better a company is.

Are you in the process of selling your company? The first thing to do is to identify “destroyers” that can impact your company’s value. Click here to download your free “Top 10 Destroyers of Value“.

Return on Equity Formula

The following return on equity formula forms a simple example for solving ROE problems.

Return on Equity Ratio = Net income ÷ Average shareholders equity

When solving return on equity, equation solutions only form part of the problem. Thus, one must be able to apply the equation to a variety of different and changing scenarios.

Return on Equity Calculation

Average shareholders’ equity, or return on equity, is calculated by adding the shareholders’ equity at the beginning of a period to the shareholders’ equity at period’s end and dividing the result by two. Unfortunately, no simple return on equity calculator can complete the job that a solid understanding of ROE can.

For example, a company has $6,000 in net income, and $20,000 in average shareholders’ equity.

Return on equity: $6,000 / $20,000 =30%

In conclusion, a company that has $0.3 of net income for every dollar that has been invested by shareholder.

Return on Equity Example

Melanie, after seeing success in her corporate career, has left the comfortable life to become an angel investor. She has worked diligently to select companies and their managers, hold these managers accountable to their promises, provide advice and mentoring, and lead her partners to capitalization while minimizing risk. At this stage, Melanie is ready to receive her pay-out. Melanie wants to know her Return on Equity analysis ratio for one of her client companies.

Melanie begins by finding the net income and average shareholder’s equity for the venture. Looking back to her records, Melanie has invested $20,000 in the business. Her net income from it is $6,000 per year. Performing her return on equity analysis yields the following results:

Return on equity: $6,000 / $20,000 =30%

Melanie is happy with her results. Because she was purposeful and started small, she built the experience and confidence to be successful. She can now move on to bigger and better deals.

If you’re looking to sell your company, download the free Top 10 Destroyers of Value whitepaper to learn how to maximize your value.

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Resources

For statistical information about industry financial ratios, please go to the following websites: www.bizstats.com and www.valueline.com.

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Return on Capital Employed (ROCE)

See Also:
Return on Asset Analysis
Return on Equity Analysis
Financial Ratios
Return on Invested Capital (ROIC)
Current Ratio Analysis

Return on Capital Employed (ROCE) Definition

The return on capital employed ratio is used as a measurement between earnings, and the amount invested into a project or company.

Return on Capital Employed (ROCE) Meaning

The return on capital employed is very similar to the return on assets (ROA), but is slightly different in that it incorporates financing. Because of this the ROCE calculation is more meaningful than the ROA. The ROCE is generally used to find out how efficient and profitable a company is from year to year. As it is a percentage a company can locate problems or areas of improvement with the fluctuation of this ratio from year to year.

Return on Capital Employed (ROCE) Equation

The return on capital employed equation is as follows:

ROCE = EBIT or NI/(Total Assets – Current Liabilities)

Note: The earnings before interest and taxes, known as the operating income, is normally used, but people can also use the Net Income if they would like to incorporate the net interest and taxes into the ROCE formula.

Return on Capital Employed (ROCE) Example

Tim found that the ROCE last year is 16%. He would like to compare this number to the current ROCE. He begins by finding the following numbers in the Balance Sheet as well as the Income Statement:

Net Income = $50,000
Total Assets = $360,000
Current Liabilities = $35,000

ROCE = $50,000/($360,000 – $35,000) = 15%

Note: The drop in this number means that Tim’s company is not as efficient as it used to be or that it decreased it current liabilities.

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