When we sit down with a new client we always start with a simple question, “How’s business?”
For many of our online marketers and eCommerce clients, this means we’re asking about sales. And of course, sales are a critical way of keeping score – in most businesses, it’s the first metric that matters. But what is the next best metric for your business? As with all things, it depends. And while the top 5 numbers for each business will differ, we’d argue that calculating Net Profit After Taxes, or simply net earnings, should be on top of every business owner’s list.
In fact, I would rank Net Profit After Taxes above regular Operating Income or Net Profit Before Taxes, and here is why: Net Profit After Taxes is THE determinant of whether you have a business or just an entrepreneurial job. Sure you have more flexibility as a business owner. But in reality, if your never-ending labor and provides zero after taxes then it’s just a J-O-B. While the reasons for starting your own business can vary, at the end of the day, if you’re not making post-tax profit and working you don’t have a business.
To better illustrate this point, we’ve done a mock “top-to-bottom” analysis, which we’ve broken down in the three tables below starting with operating profit as shown in the financial statement (Table 1), to a tax-adjusted Net Profit After Taxes number (Table 3).
First, we show financial statement profit, or what might be showing in your Quickbooks, Xero, or Wave accounting software. This is what business owners are most accustomed to seeing. As an example, we’ve shown average numbers for an eCommerce client below in our first 2-3 years of working with them.
Table 1: Financial Statement of Net Profit
As you can see, on revenues of $140,000 the company has net profit of $55,000. Not bad, right?
But how do taxes change that number? Do I still have $55,000 after I pay Uncle Sam?
Well, let’s just say that this company is an LLC on cash-basis accounting. And to calculate the self-employment taxes and a 20% average federal income tax rate, we estimate a 35% tax rate or about $19,250 in taxes.
That leaves us with $35,750. But this isn’t accurate.
We haven’t yet looked at operating expenses in detail to determine how much of the total operating expenses are actually deductible, that is whether the tax authorities will allow the subtraction of those expenses from taxable income.
To calculate that, let’s take a look at a tax view of our financials. That means taking an in-depth look at the deductibility of our operating expenses. It’s important to note that while cash withdrawals look like an expense for financial purposes, these look like income to the IRS.
So after adjusting for meals, entertainment, travel, obvious personal spending (hopefully minimal), and major cash withdrawals, we calculate that only $20,000 of our $40,000 is deductible. Meaning that for tax purposes, our operating expenses are lower, and our income is higher, which changes taxable income to $75,000. See below for more detail.
Table 2: Business Tax Calculation
So while you aren’t seeing that amount of cash in the bank, you are now seeing higher income, which means higher taxes. Applying the same tax rate, we get $26,250, much higher than our original calculation. Are you now feeling the pain of adjusting for deductibility?
Finally, we go back to our original financial statement which reflects all expenses in the business and take actual taxes owed of $26,250 and insert it into the Taxes line in Table 1. Our results are shown in Table 3.
Table 3: Net Profit After Taxes
As you can see, the Net Profit After Taxes now shows as $28,750, a $7,000 or 5 percent drop from our original calculation. What if I told you your tax bill was zero and moments later that it was actually $7,000? For most business owners, financial surprises are never good ones.
As you can see, by calculating Net Profit After Taxes, you tackle critical obstacles and come across important metrics along the way. So far we have discussed:
- Net Revenue Less Returns,
- Financial Net Profit,
- Tax Deductibility, and
- Tax Liability.
And while no one likes to pay their tax bill, the good news is that now you have a realistic picture of what your business makes and exactly how much you’ll pay in taxes. For this client, that value for the year is $28,750.
For most business owners, after they see the baseline, the real strategy begins: planning and setting goals.
From a tax perspective, you can check with your tax advisor to see what deductions you’re missing if there’s an opportunity to re-invest some of the business’ cash or prepay liabilities to cut down your tax bill.
From a financial perspective, you might realize you need to focus on cost controls, set higher revenue goals, or more closely monitor your return on investment from a certain expense such as advertising.
And don’t be surprised if your focus changes entirely or if your top 5 metrics change completely after you’ve analyzed your Net Profit After Taxes. Ultimately, this business is yours and how you want to run it financially and operationally is up to you. But in any event, doing a top-to-bottom analysis will help you intimately know your numbers, assess where you are, and give you clarity on where you’re going and how to get there.
Finally, we hope you’ve realized a very important factor in determining tax: Deductibility. Knowing how to avoid traps like cash withdrawals is critical. And knowing what deductible expenses are for your business is a must.
In our next piece, we’ll cover deductions by business type, to help you avoid pitfalls and take advantage of easy deductions for your type of business.