The Relationship Between Profit Margins and Cash Flow

profit margins

Cash flow problems affect 60% of small businesses each year and for many reasons: late-paying customers, too much cash tied up in inventory, and so on. However, one often overlooked reason for cash flow problems are low profit margins.

In order to stay in the game, many small businesses find themselves reducing prices and taking a cut in profit. It’s a risky venture. While price breaks can pay off in terms of more sales, it’s a strategy that could damage your brand and reduce the amount of cash in hand you have to pay your bills.

If you’re at the point where you’re feeling the pinch and have already tried other ways to improve cash flow, then it may be time to reassess your profit margins.

6 Tips for Evaluating Your Profit Margins

  1. Start with Your Profit Calculation

    Different industries have different profit margins, but a breakeven analysis can help you determine at what point you can reach a cash flow positive situation and make a profit. This is called net profit, which is different from gross margin, which reflects the profitability of a single product or service. You’ve broken even when your revenue equals all your business costs or overheads (fixed and variable). This exercise can take time, so don’t rush it. Make sure you’ve captured all the costs that your business incurs, everything from payroll to paper clips.

  2. If Profit Margins Are Good

    If your profit margins prove to be good, then you may want to look into other avenues for increasing your bottom line. But be careful. If cash flow is tight, your business may not be able to tolerate the costs of driving growth or entering new markets. Check out these tips from my fellow Fundbox blogger, Justin Reynolds, on how you can overcome cash flow gaps by investing in new products, markets, and initiatives.

  3. If Profit Margins Are Low

    If your margins are dire, find out why. If your costs are too high or you’re reinvesting your profits back into your business, then you can quickly come up short in terms of cash flow. Can you decrease your expenses, practice more lean business practices, or reassess supplier relationships and renegotiate contracts?

    Your profitability will also inform other business decisions you make. For example, if your margins aren’t that healthy right now, you may want to hold off making large business purchases.

  4. Don’t be Afraid to Increase your Prices

    Are you unwittingly underpricing your services? It’s a common problem for small businesses because they lack the operational efficiencies that larger firms have and often find out, too late, that the cost of doing business is higher than they anticipated—whether you’re a carpenter buying wholesale lumber to complete a deck-build project or you’re a consultant and misjudged the scope of a project.

    Before you increase your prices (or even just right-size them), be sure that you have a robust value proposition (or perceived value) and a solid reputation to support your price point. Test different prices in certain markets or geographies to see if the demand for your product is impacted and help you find the right selling price. To reduce the likelihood that you’ll discourage customers from supporting your business after you raise prices, check out these tips.

  5. Look to Your Competition

    Don’t just look at your profit margins and price points in isolation—consider your position in the marketplace. Where do you want your brand to be in the grand scheme of things? Could you differentiate your business sufficiently from the competition to position it at the higher end of the market where your current competitors aren’t? Is there a market there? What strategy will get you the best penetration in that market as quickly as possible?

  6. Add More Women to your Management Team

    Finally, how about adding more women to your management team? No offense fellas, but a recent study from the Peterson Institute for International Economics suggests that the presence of women in corporate leadership positions may improve firm performance. As reported here by “…a profitable company in which 30 percent of the top executives are women would expect to be about 15 percent more profitable than one in which the C suite is all male. Unprofitable companies gain even more.”

Check out these blogs for more cash flow and financial management tips.

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Tags: FinancingRunning a Business