The Guardian, November 2004 Business Solutions supplement: Feature on profits versus revenues

Its easy as a small and growing business to be dazzled by big deals with large price tags to the point where profitability and therefore the health of the business - gets forgotten. Its one of the biggest reasons why small firms go under.

Which would you prefer a 5 million-turnover company making 100,000 profit a year, or a 500,000-turnover business making 200,000 a year? cautions Jeremy Cooper, a partner at accountancy and business advisory service provider Horwart Clark Whitehill LLP.

Accountants warn about sales being for show, profit for dough, and thats for a good reason, he warns. You have to be in business to make a profit; otherwise the company will fail. Think back to the IT/Internet bubble of the late 1990s companies were given huge amounts of money to develop IT businesses, with many surviving for only a few years before burning their investors funds. Why did the cash eventually run out? Because the businesses expenditure was greater than their income, and the business models were incapable of ever making a profit in the first place.

Its not always obvious where a companys real profits come from, though. Restaurants, for example, make their highest margins on drinks, whereas pubs make their money on food. Petrol stations, meanwhile, rely on their forecourt shops to compensate for paltry margins on fuel.

Its important, therefore, that businesses can tell the difference between revenues and profits, and understand the role and contribution of each product and service line from both these perspectives.

For many businesses, while their core business is whats put them on the map and brings in the customers, its their more peripheral, value-added activities that generate the companys profits. Both are clearly crucial; the trick is recognising which activities perform which financial function, and what could happen if one part of the business grows more rapidly than or at the expense of - the other.

When former Web programmer Mike Fenney set up his Internet-based diving log business 18 months ago, he learnt this the hard way.

Like many entrepreneurs, Fenney started his business based on a good idea borne out of his own experiences as a consumer. As a keen diver, Fenney had spotted a gap in the market for a convenient way of keeping a dive log the records people keep of their diving experience for safety purposes.

You get a log book automatically when you qualify as a diver, but after two years you need a new one and the ones available were too big and chunky.

Fenney found a small, waterproof binder at Office World and designed his own, easier-to-use pages to make a dive log he could use on his next diving holiday. He was so pleased with the results that in July last year he launched the product as a Web-based business (see www.dive-logs.com).

Although revenues have grown through the roof since he started the business, the company only broke even in June this year; until then Fenney had been trading at a loss.

While he had a good core product that had been well received from the outset, Fenney had made the decision to sell this at a price that undercut comparable products, while adding value through the enhanced user-friendliness of his own offering. This would make the product a no-brainer and draw potential customers in their thousands.

After an initial 6-9 months setting up period, Fenney saw the business take off at lightning speed. We experienced a huge growth spurt, expanded globally, and extended the product range so that we became a one-stop shop for everything associated with dive-logging, he says. The portfolio now includes a customisable log-book stamp, cards illustrating the different fish to look out for, and log-book refill pages.

Turnover now fluctuates between 4,000 and 5,000 a month, ranging up to 8,000 if there has been an event such as an exhibition. Yet, although the business is a one-man band, and is Internet-based, even these figures havent been enough to sustain much of a profit.

I expected an increase in revenues to result in an increase in profits, but the fixed costs have gone up too, Fenney admits. To support a growing online customer base, for example, Dive Logs had to move from a shared, hosted Web server service to a dedicated Web server, to increase reliability. I once lost 100 of sales when the previous server went down for an hour; I couldnt afford to be in that position again, he says.

Another substantial cost has been marketing essential to a new business. In February, I decided to boost this to generate greater volumes of new business, Fenney recalls. The temptation was to chuck money at this and I probably spent 3,000-4,000 more than I really wanted to. This included being talked into doing an advertorial in a diving magazine, which cost me 1,000 and yielded nothing. In contrast, I paid 250 to do an email newsletter which led to lots of orders.

With the initial set-up costs and learning curve out of the way, Dive Logs crossed into the black in June, and now turns in a modest monthly profit of 1,000. Ultimately, Fenney is looking for a minimum monthly surplus of 4,000. Key to this, as well as remaining true to the business plan and not being seduced into over-spending on advertising, is making sure the business comprises the right balance of value-added activities to core, lower-margin, standard products.

So, while Dive Log offers its basic binders for 10 compared to a market average of 15, Fenney aims to make his real profits on consumables the refill pages that need to be continually refreshed, drawing customers back time and time again. He designs, prints and distributes these himself, to maximise margins.

Of course there are other important factors to bring into the equation, too, such as being able to offset operating costs against more than one business activity, and the rather substantial matter of cash something else that gets forgotten in the pursuit of broader riches, but which can be the undoing of the smaller firm.

I like to explain the profit versus sales conundrum with a simple analogy: your business is a car, turnover is the petrol, cash is the oil your engine needs to run, and profit is the distance covered by your car, says Paul Samrah, a partner at chartered accountancy practice Kingston Smith. Clearly you want the car to take you places, to make profits. Poor turnover will clearly restrict you, but a lack of cash could cause the business to falter or breakdown just when you think youve taken care of all the obvious, important things.

Cash is king, concurs Toby Stephenson, a partner at accountants and business advisory firm PKF, citing an old accounting clich� Many businesses expand by pushing revenues without thinking about the cash flow effects, or the increased working capital that will be required. These can be significant and have resulted in companies facing financial crisis when left unchecked.

This has implications for any business with a demanding production cycle, where resources may be scarce and bottlenecks possible, which may mean large, additional fixed costs may have to be incurred if production capacity needs to be increased.

Another red-alert situation is when a substantial contract comes up, he warns: Although this can give a small company a dramatic boost in both turnover and profitability, often the company will become reliant on that customer and in turn the customer may hold the business to ransom. To avoid this risk, small companies need to be flexible and able to upsize or downsize quickly, perhaps using subcontractors, or tie the large customer to a term contract.

Big companies are also notorious for delaying payments, adds Roger Martin Fagg, a lecturer on business management at Henley Management College. So always look at when customers will pay out and have this agreed in advance. A delay of three weeks could close your business, so get the customer to realise the importance of paying on time, or in instalments if necessary.