Remember that your net profit is the money that comes out of your business in the same way that a fisherman takes fish out of the sea. If there are no fish, you have nothing to eat.
Recently, I was told the sad story of a company that went bankrupt because they made the wrong sort of profit. So what went wrong?
Andrew Shaw*, a business angel, told me about a company called Travel Stars* that he invested in. Travel Stars’ story was reported in the local news and on TV as the “wicked credit card company closing down an honest trader”. It was true, the bank cancelled the Travel Stars’ merchant status and since 95% of the customers paid by credit card, the company went insolvent overnight.
What was the real story?
Travel Stars put together itineraries for people looking for customised tours around the world. It made $500 profit on every sale (the average sale was $1500).
So the founders pitched a great deal to investors: all they needed to do was spend more money on marketing, which would increase the number of customers and they’d be creating $500 profit for every sale. They had created a “sausage machine”- capital in, profit out. Even better, customers were happy and writing great reviews about the service. They went to business angels and venture capitalists and, after a lot of effort, raised another $500,000 for marketing. Success.
Or Was it?
Once the money had been paid over, Andrew had difficulty getting a full set of accounts. He hounded Travel Stars, but no information was provided. The only thing he could see was that the bank account started to go down rapidly and it began to look like Travel Stars would need more money. This was inexplicable since there was supposed to be more profit.
The next thing that happened was a phone call from the bank to the Travel Stars CEO. Travel Stars had a bond with the bank since their business model allowed it to collect money from customers and pay for the customers’ service at a later date. Under the credit card agreement, if Travel Stars went under, the bank was liable to the customers for their funds. The bank was concerned that if Travel Stars went under there would not be enough money to repay customers for the service, so they asked for the bond to be increased. Travel Stars did not have enough money to increase the collateral.
So the bank cancelled merchant status. The company folded. Customers got most of their money back.
In the aftermath it became clear that the managing director of Travel Stars had misunderstood the sort of profit he was making. He was making a gross profit of $500 while everyone assumed he had meant net profit. Gross profit is the amount that remains after deducting cost of goods sold while net profit is that which is left after all expenses, interest and tax are deducted.
So they had bought in product at $1000 (cost of goods sold) and sold it for $1500. So the gross profit was $500 ($1500-$1000).
Gross profit has to cover all the costs of running the company – the staff, business systems, rent, interest, tax, insurance etc – and leave some over, which is called the net profit. But when you took the cost of running the company and divided by the number of sales, you got a cost of $1300 per sale.
No wonder there were great reviews of the company. Customers were paying $1500 and getting $2300 of value.
Doing the maths
Put another way, each Sale cost the company the variable cost ($1000) plus a share of the fixed cost ($1300) for a total of $2300. Each sale brought in just $1500. So every time Travel Stars sold something, it cost the Company $800.
No wonder there were great reviews. Customers were paying $1500 and getting $2300 of value. Who wouldn’t be happy?
The creditors – they were unhappy! The investors – they were definitely unhappy!
Every sale that Travel Stars made caused the company to go into debt a further $800. In fact, the investment sped up the demise of the company because it ramped up its sales! In the end the bank did everyone a favour: it stopped the company continuing to lose money.
So gross profit is the amount you make before you pay things like your salary, the rent and rates, insurance, and your employees. And net profit is what is left in the business for following year. A negative net profit means you will go out of business.
A late learner
Richard Branson was 50 when a fellow director realised he didn’t know the difference between net and gross profit. So the director pulled out a bit of paper and he drew the sea and a net in the sea, then he said, “The fish in the net, now that’s your profit at the end of the year, and the rest of the sea, those fish that aren’t in your net, that’s your turnover”.
So remember that your net profit is the money that comes out of your business in the same way that a fisherman takes fish out of the sea. If there are no fish, you have nothing to eat…
* Not their real names
Brian Dorricott, Managing Director, Meteorical
This article first appeared in issue 9 of the Inside Small Business quarterly magazine