The goal of every business is to make money. I know. However, how do you accurately measure profitability?
Recently, I came upon a book that explained these axioms very nicely. It’s called The Goal – An Process of Ongoing Improvement. It is a fun novel with embedded strategies about business and operational constraints.
Net Profit
It’s not as simple as how many small businesses operate their finances (money in minus money out = profit). Wrong. There are many other factors to consider, such as depreciation, discount rate, cost of goods sold, and so forth.
While this is a good start, you still need to consider ROIC.
ROIC
ROIC (return on invested capital) is one of the fundamental formulas in finance. It is your net operating income (less wages and cost of goods sold) minus the sum of taxes owed and dividends paid all divided by the invested capital.
So, let’s imagine that you made $1M this year, but you had to invest $1 billion. That’s 0.1% return. Is that a good investment?
Despite seemingly healthy profits, you must generate a good return for your investment.
Cash Flow
There are many “profitable” businesses that go bankrupt. The reason is because there is no cash flow (money coming in to pay operating costs — rent, utilities, wages, etc.).
Cash flow might be plugged up because everything could be dealt on long term credit (accounts receivable). All clients promise to pay very far in the future. And it doesn’t help if there is no reserve cash to maintain operations.
All in all, even if you are in the black (profitable) on paper and you have an attractive ROIC, without cash flow, there is no firm to run. All three must be congruous for a successful business. Keep those gears running.
Sincerely,
Lawrence Chan
P.S. When everything is set in motion, relax. How do you like to relax? Comment below!
I like to relax by drinking coffee and reading novels. I could do that for hours.
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I like to relax by reading your well articulated articles and peruse through your Instagram photos. I also drink wine or coffee. π
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Oh, Kenny. You flatter me. π
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For me relaxing is playing games with my daughter. She is great at making the world disappear. Oh and coffee is great too! π “The Goal” is a great book that really made an impression on me. It was the first “business” book I ever enjoyed reading and opened me up to the idea that complex ideas can be explained through stories that are easy to read and understand. So happy that you stumbled upon it as well!!!
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That’s wonderful! Family is a great investment and outlet.
Also, I love how the book outlined bottlenecks and its relationship to demand.
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For me, relaxing is spending time outside with friends and family with no agenda.
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A good movie or book will do it π
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