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.

the goal - a process of ongoing improvement

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.

roic formula

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.

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Sincerely,

Lawrence Chan

P.S. When everything is set in motion, relax. How do you like to relax? Comment below!

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