This week was a challenge and a huge opportunity.
I have been reading “His Needs, Her Needs” by Willard F. Harley, Jr. in an attempt to better my relationship with my wife. It is a pretty good book that lays out a case for biological and societal conditioning that creates needs (different needs) for men and women. Read More
Net income is for your taxes, EBITDA is for investors, and Net Operating Income is for business owners.
When I started my first business, all I cared about was making money. I thought that if I spent less money than I brought in, my net income would be positive and life would be good. I operated my business profitably for years, but I missed a number of great opportunities to make a lot more.
Why? Because, my vision was clouded by one-time expense events, interest expense, and one-time revenue windfalls.
Let me give you an example, in January of 2002, I experienced a theft of computer equipment. I lost about $25,000 worth of servers, laptops, etc. When I submitted the claim to the insurance company, they paid me $25,000 less my deductible. I forgot about that settlement months later when I was looking at my financial statements, and I erroneously believed I was more profitable than I actually was because I characterized that insurance check as normal revenue.
The problem was that my business model did not produce this $25,000 increase in net income. Perversely, a theft created it. I unwisely believed that my business was doing better than it actually was, and, as a result, I made no changes to expenses, pricing, or sales commissions.
Unfortunately, my “net income” calculation fooled me, and I fooled myself, but in a business with over 40,000 transactions in a year (doing about $3 million in revenue), I could not keep all of the transactions straight in my head. As a result, I made some bad decisions and left money and profits on the table all the while thinking I was doing great.
Here is a second example:
Many businesses use loans from banks to finance their company. The interest from these loans is an expense. It reduces Net Income, lowers taxes, and must be paid. Take a furniture company where loans are an integral part of the business. In a furniture company, loans are commonly used to finance the purchase of inventory and keep furniture (inventory) on the showroom floor.
I know of one furniture company owner (let’s call her “Suzy”) that thought her business was performing horribly in 2005 and could not figure it out. Sales were rising, she was expanding into new territories, taking on additional loans, the economy was booming, and yet her net income was flat to negative each of the past four years.
The problem was not in the operations of her business, but by only looking at the traditional metric of “net income”, it was hard to tell what was causing the problem.
The real problem, as it turned out, was that her financing costs had skyrocketed. The interest rates had risen and as she took on more debt, the banks required additional fees and expenses to satisfy their loan demands. Unfortunately, Suzy was using her “net income” rather than “Net Operating Income” to make decisions, and because sales commission expense had increased greater than interest expense (and she didn’t feel like she could control interest expense), she decided to cut sales commissions to increase profitability.
That turned out to be a bad move. Salespeople quit and took jobs with her competitors, and Suzy nearly went out of business.
What Suzy failed to recognize (as do most business owners) is that how you “finance” your business is very different from how you “operate” your business. This is confusing, so bear with me.
If Suzy had all the money in the world, and used her own money rather than the bank’s money to finance the business, she would never have needed to incur interest costs. Bank loans are not a mandatory part of any business, and they are not an integral part in any business model (unless of course you are a bank). Loans are only a financing instrument. Interest is a cost produced by those loans.
Without interest costs, Suzy would have been more profitable than her competitors and happy with her operational performance. Unfortunately, with interest costs clouding her vision of the true operations of the business, Suzy nearly lost her business because of a bad business decision.
Use of the concept of “Net Operating Income” rather than “net income” helps avoid the problems that I faced with uncertain revenue and the problems that Suzy faced with her runaway interest costs. Net Operating Income takes those non-operational items and moves them out of your Net Operating Income calculation and only takes them into account as “one-time” or “non-operational” expenses.
Even non-operational income and expense items are important to manage, but you should never give a price break because you received insurance proceeds, and you should never increase prices because you are paying interest on loans. Both of these decisions will make you less competitive, less profitable and ultimately make your business less valuable.
Interest costs are non-operational and one-time revenue windfalls are non-operational. Both of these types of income and expenses are called “Other Income and Expense Items” and should be classified after figuring out your Net Operating Income. Doing so, will leave you with a figure, “Net Operating Income,” that accurately represents how well you are operating the business model.
So how do you set up your income statement to show you Net Operating Income?
Step 1: Start with Revenue – Use only revenue that was generated in the active operation of your business. For example, if your business is a delivery business, it is all of the fees you charge for deliveries. It is not the money you made selling one of your trucks. It is only the money generated by operating your business (not the random events that make a little extra money here and there).
Step 2: Subtract all of your costs to provide your product or service (Cost Of Goods Sold) to arrive at your Gross Profit.
Step 3: Subtract from your Gross Profit all of your Sales, General and Administrative expenses (pretty much everything that is an essential cost of running your business).
What you are left with is “Net Operating Income”.
So where do you put those non-operational or one-time revenue and expense items?
Well, once you get to Net Operating Income, you have an additional line item after Net Operating Income called “Other Income and Expenses”.
In that line you add any one-time revenue that is not a part of your traditional business model (things like tax rebates, one-time discounts, lawsuit winnings, etc.), and subtract any one-time and non-operational expenses (things like interest, moving costs, storm and theft losses, etc.).
Here is what it looks like for Suzy:
Revenue from Furniture Sales: $5,000,000
Cost of Goods (furniture): $3,000,000
Gross Profit: $2,000,000
Sales, General and Administrative: $1,500,000
Net Operating Profit: $500,000
Other Income and Expense (interest): $300,000
Net Income: $200,000
So, is Suzy making $200,000 or $500,000? She is only paying tax on $200,000, but she is making $500,000 from the operations of her business. Remember, she does not have to use bank financing to fund her business. What if she had enough money to self-fund? What if she had an investor? What if she had a wealthy Aunt?
As it turns out, Suzy is doing pretty good. At a Net operating Income of $500,000 she can afford to pay those salespeople the appropriate level of commissions, and when compared to her peers, she is actually a bit more profitable than the industry standard.
She would never have known that without focusing on Net Operating Income, and now she can focus on growing her sales, fine tuning her operational expenses, lowering her interest costs, and making more money.
Stay with Net Operating Income to measure the effectiveness of your business model and your management of the business model.
Keep one-time items and bank loans separate, and analyze them on their own to determine whether you are financing the business effectively.
Use your Net Equity to gauge the safety and security of the business, and use Net Cash from Operations to determine how efficient you are at managing cash.
This is the Triple Bottom Line and it works.
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