The power of profit margin
After six months of work, my guide about becoming the Chief Financial Officer of your own life is ready for launch! Be Your Own CFO will be released on April 22. Over the next couple of weeks at Get Rich Slowly, I'll share some background on this project, including excerpts and outtakes. Today, for instance, I'll give you a taste of what I've written about the importance of profit.
The overall theme of my new guide is that people would have greater success managing their money if they acted as if it belonged to a business. I think most of us understand that companies can't exist without profit. But for some reason, people don't practice this concept in their personal lives — even though the same principle applies!
The Importance of Profit
Profit is the life-blood of every business. It's like food and water for the human body. Although proper nutrition isn't the purpose of life, we can't exist without it. Food and water give us the strength we need to pursue the things that bring us happiness and meaning. Similarly, profit isn't the purpose of business, but a company can't survive without it.
Companies that forget (or ignore) the importance of profit often become unable to meet their goals. Instead of pleasing customers or developing new products, they find themselves in a struggle to survive. A good Chief Financial Officer aims to maintain and maximize profitability.
Individuals need profit too. If you're living paycheck to paycheck — or worse, sinking into debt — you'll find it impossible to accomplish the goals you've set for yourself. Plus, today's profit acts as a safeguard to protect you against an uncertain tomorrow. It also provides flexibility, giving you more options and allowing you to seize more opportunities. What's more, you can invest a profit, growing the money for future needs, such as retirement.
The bottom line: To fulfill your dreams, you must earn a profit.
Profit is simple to calculate. It's your net income, the difference between your revenue and expenses. If you earned $4,000 last month and spent $3,000, you had a profit of $1,000. But if you earned $4,000 and spent $5,000, you had a loss of $1,000.
This idea is expressed by a simple formula:
Since the beginning of this blog, I've called this the fundamental equation of personal finance. If you spend more than you earn, you're operating at a loss; you're losing wealth and in danger of going into debt (or, if you're already in debt, you're digging the hole deeper). If you spend less than you earn, you're producing a profit and building wealth, which can be used to pursue your goals.
Your net worth is the accumulation of years of profits and losses. The greater the gap between earning and spending, the faster your net worth grows (or shrinks). This may seem obvious, but it's important. Everything you do — clipping coupons, saving for retirement, asking for a raise — is done in support of this basic idea.
Because this equation is so simple, there are only two ways you can boost profitability:
- You can spend less. A business can increase its profit by slashing overhead: finding new suppliers, renting cheaper office space, laying off employees. You can increase your personal profit by spending less on groceries, cutting cable television, or refinancing your mortgage.
- You can earn more. To generate more revenue, a business might develop new products or find new ways to market its services. You might earn more for yourself by working overtime, taking a second job, or selling your motorcycle.
All financial advice is based on the fact that these are the only two ways to boost your profit. You must spend less or earn more. There are no other options.
The Power of Profit Margin
While it's helpful to track profit as a raw number, it's even more useful to track profit margin, which measures a company's profit as a percentage of its income. For instance, if a business had a profit of $30,000 on $200,000 sales in 2013, the company's profit margin would have been 15 percent.
In recent years, the average large American company has had a profit margin of roughly 9 percent. Although they vary by industry — accounting firms tend to have higher profit margins than manufacturing businesses — small businesses generally run margins between 5 and 15 percent.
In personal finance, the profit margin is called a saving rate, and it measures the percentage of your income that has been set aside to pursue future goals.
The economic definition of saving is “current income minus spending on current needs,” which is essentially the same definition used to calculate profit on an income statement! Unspent money is money saved. It's profit.
Profit margin is a vital metric of business success, and saving rate is an important tool for measuring your personal financial progress. It might, in fact, be the most important number in all of personal finance. Saving (profit) over time builds wealth (net worth).
Finding your saving rate is simple. For any given period of time, divide your profit (total savings) by your total income. This number, expressed as a percentage, is your saving rate, your profit margin.
When you begin to earn even a small profit, the balance of power shifts in your favor. With a profit, you don't have to worry how to pay your bills. Profit allows you to chip away at the chains of debt. Profit removes the wall of worry and grants you control of your life.
How Much Profit Do You Need?
Most financial advisers urge people to save 10 percent of their income. The bold ones recommend 20 percent. Profit margins like this are small enough to seem achievable yet large enough to allow pursue their goals (albeit slowly). A savvy CFO will treat these recommended profit margins as only the beginning.
If you were to maintain a steady profit margin of 10 percent, it would take nine years to save enough to fund one year of living. (Or, to think of it another way, if you maintain a saving rate of 10 percent for nine years, you'll accumulate enough to take one year off work.)
With a profit margin of 20 percent, it takes only four years of work to fund one year of expenses. With a 50 percent margin, you're saving enough each year to fund another entire year normal spending! And at 75 percent, each year of work would fund three additional years. (Another way to look at this: After three months with a 75 percent saving rate, you could take the rest of the year off from your job — assuming your boss would allow you to return.)
This table shows the power of profit margin:
This table is taken directly from my upcoming Be Your Own CFO guide.
Your profit margin affects how quickly you'll achieve your goals. A profit margin of 20 percent will allow you to reach your destination twice as quickly as you would with a profit margin of 10 percent. But if you can save 40 or 60 percent, you'll get there even quicker.
The more you save, the more profit you generate, the sooner you can do the things you dream of doing.