The 20 Percent Profit Myth
Originally published: 02.01.15 by Ruth King
For a realistic goal, include owners' compensation in the net profit equation.
Some HVACR business owners brag about getting a 20 percent net profit on a continual basis. I've reviewed and analyzed thousands of financial statements over the past 27 years from well run, profitable companies and I've come to this conclusion: a 20 percent net profit on a continual, year after year basis is a myth.
I can make any financial statement show a 20 percent net operating profit by inflating revenues and holding expenses until the next year. If you report financials on a cash basis raher than an accrual basis, this is really easy.
Cash basis accounting has no accounts receivable, accounts payable or inventory. You record a sale when you get the revenues and you record an expense when you pay a bill. Just get the cash in the door and don't pay your bills until your next fiscal year and you can achieve a 20 percent net operating profit.
On an accrual basis, your gross margin is consistent and you can see true profitability from month to month because you record all revenues, whether or not you've been paid and you record all expenses. To achieve a 20 percent net operating profit, simply pre-bill customers at the end of the year and don't record supplier invoices until the following year.
I've seen a few owners who've achieved this once when they had a blazing hot summer and a bitterly cold winter. They also stressed out their staff, didn't take a reasonable salary and didn't hire additional people when needed. They burned out themselves and their staff — and each one told me it wasn't worth it.
Most contractors have a loss during the first three months of the year, or during some three-month period of their fiscal year. To earn a 20 percent net operating profit for the year, the remaining nine months have to be more than 27 percent each month. And that assumes you have zero net operating profit the first three months rather than a loss.
If you have a large maintenance agreement base (more than 3,000), that base keeps you at break even during slower times but is unlikely to generate a net operating profit of 20 percent during the months you perform mainly maintenance checks. If you're at break even, you'll still need to generate more than 27 percent each month in the remaining months.
If you're an LLC and have a draw, that draw usually doesn't show up on the P&L statement. It's a balance sheet entry. This is another way to show a 20 percent net operating profit.
If you're a start-up without an office and pay yourself only a modest salary, do not have rent, utility bills or warehouse expense on your profit and loss statement, you could have a 20 percent net operating profit. In reality, you have those expenses, you're just not accounting for them. If you don't pay yourself, at some point you'll realize the business isn't worth it.
Achieving a net operating profit of 20 percent is impossible in what I call “no man's land.” These are the revenue stages where your company must add overhead to survive and grow to the next level.
In no man's land, you have less profit because of the additional overhead needed to operate the business. As the company grows out of these stages, higher profits reappear.
Another way to show higher profits is to omit depreciation, bad debt and other non-cash expenses from your P&L statement.
I wouldn't want to pay taxes on a net operating profit of 20 percent. I'd prefer to take the money in salaries, establish a profit sharing and retirement plan for employees or other legal tax strategy.
Owner's compensation plus net operating profit should be 20 percent or higher. When a company is valued for a potential sale, owner's compensation is calculated at 10 percent. If you're taking less than 10 percent of sales in compensation, then the difference is subtracted from profits.
When you include compensation in the net profit equation, you're truly comparing your company profitability with other companies' profitability. Some owners take a huge compensation and leave little in the company. Others take a smaller compensation to show higher profits. Including compensation makes comparisons realistic.
Set your goal to achieve a 20 percent net operating profit including owners' compensation each year. This goal is prudent and reasonable.
Ruth King is president of HVAC Channel TV and holds a Class II (unrestricted) contractors license in Georgia. She has more than 25 years of experience in the HVACR industry, working with contractors, distributors and manufacturers to help grow their companies and make them profitable. Contact her at firstname.lastname@example.org or call 770-729-0258.