It’s an unfortunate fact that 1 out of 5 small businesses go out of business in just their first year. That’s why it’s crucial that you need to try to become profitable as quickly as possible. To calculate the profitability of your business, you’ll need to figure out your operating income. This is the net profit you’re left with when you take your business’s revenue and then subtract the expenses you had to pay for. Other terms for this include income from operations, operating earnings, and operating profit.
Potential investors and creditors tend to pay attention to your operating income, as it gives a nice indication as to the chances of future growth for your business. If you have a negative operating income (your expenses are greater than your revenue), then the prospect of future growth is less likely than if you have positive operating income.
So one of the skills you need to learn is to calculate your operating income. The good news is that this isn’t really all that difficult or time-consuming.
Start with Your Gross Income
The gross income is the money your business earns before you deduct anything (like your taxes) from it. Creditors tend to look at this figure in particular, as it shows how much money you’re able to borrow. Basically, lenders only tend to lend money in amounts that don’t exceed your gross income.
Subtract Your Operating Expenses from the Gross Income
The operating expenses are the things you pay for so your business can actually operate. These include paying for such things as:
- Rent for your shop or office
- Utilities, like electricity and water
- Supplies, which include office supplies, computers, and various tools that you may need to run your business. If you’re running a pizza parlor, then you may need to buy a wood-burning oven.
- Wages for your employees
- Any sales commissions if you employ salespeople
- Insurance fees
- Legal fees
- Costs of goods sold: Known as COGS, this is the sum of the cost of your beginning inventory and purchases while subtracting the cost of your ending inventory. These purchases include buying more merchandise and the cost of producing more products. At the end of the year, you subtract the products you haven’t sold yet.
Depreciation and Amortization
These are the expenses accounting for the costs of your assets during their lifespan usage. Often the term “useful life” is used for the estimated lifespan of your asset, such as how long you’d expect your wood-burning oven to last for your pizza parlor.
Depreciation is for your fixed or tangible assets, like your office furniture, work equipment, vehicles, buildings, and land. The depreciation is calculated by getting the original cost and then subtracting the resale value of the asset. It’s much like buying a brand new car for $40,000 and then a year later you can only sell it for $30,000. In that case, the car depreciated by $10,000 or 25%.
For your business, you also need to factor in the estimated lifespan. What if you bought a work tool that costs $20,000 and you expect it to work for you for 10 years. Then after 10 years, the resale value is now only $4,000. The formula, in this case, will be:
($20,000 – $4,000) / 10 years = $1,600
This means that your business spends $1,600 a year as operating expenses for that work tool.
Amortization is a similar concept, except that it applies to intangible assets. These can include your franchise agreements, copyrights, patents, and trademarks. These don’t generally have any resale value at all, but they do have costs and estimated lifespans.
A Theoretical Example
Let’s say you have a business selling accessories to motorcycle owners. Your small startup is now growing with more and more customers demanding your products. You’re taking in $$350,000 in sales this year.
To accommodate the growing demand, you’re thinking about moving to a new shop and maybe hiring more people. But that will mean asking the bank for a loan.
You can demonstrate to the bank that your business is doing well by providing your income statement. Perhaps your expenses look like this:
- Rent for the shop: $48,000
- Utilities: $8,000
- Employee salary: $36,000
- Insurance: $3,000
- Inventory: $100,000
- Tools: $26,000
- Depreciation: $$1,200
With $350,000 in sales and then subtracting the total of $222,200 you get $127,800. Since you’re able to show that you can generate a profit with your business, you’re more likely to get approved for a loan. If the bank is feeling generous, then the limit can go up to a $350,000 loan, as this represents your gross revenue.
The Google Example
Google has been publishing its income statement over the last few years, and you may do well to follow their example too.
Revenue for the end of 2017
- Total revenue: $110.885 billion
- Cost of revenue: $45.583 billion
- Gross profit: $65.272 billion
Operating expenses 2017
- Research and development: $16.625 billion
- Selling, general, and administrative expenses: $19.765 billion
- Total operating expenses including cost of revenue: $81.973 billion
- Operating income: $28.882 billion
Yes, Google earned an operating income of almost $29 billion, which explains why it’s one of the top companies in the world. This company is extremely profitable, even though most people only know it for its free search engine.
If you can figure out your operating income, then you get a better sense of your company’s profitability. It’s no good if you’re earning $10,000 in revenues each month only to discover that you’re spending $12,000 a month running your business. You’re operating at a loss, and this can help you to fix what’s wrong with your business.
It’s best if you can increase your operating income instead. This may mean improving revenues while trying to cut back on your various expenses. If you can find ways to cut down on unnecessary expenses while you improve sales, then you’re well on your way to making your business profitable at last. When it’s time to grow your company, your profitability can look good for investors and creditors alike.