Profitability is Important at All Levels

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As earnings season cycles around again, publicly traded companies will release results for last quarter and for the year-end. Smaller, closely-held companies are busy too as many close out their tax year, fund profit sharing plans, and put together their final year-end financial statements.

Even at the family level, financial activity is high this time of year. Soon W-2’s and other tax-related documents will be available so individual tax returns can be completed by mid-April.

Most publicly-traded corporations, closely-held small businesses, and individuals, as they busily work their respective end-of-year tasks, will unknowingly gloss over their most important financial result: profitability.

In a capitalist society profitability is the ultimate financial reward, and too often we miss its importance. Stock prices are driven higher by a multitude of factors, so there are quite a few unprofitable corporations with enviable valuations. However; fairly recent studies have shown profitability to be a relevant indicator of above-market returns in large cap stocks (see A Five-Factor Asset Pricing Model by Gene Fama and Ken French). Successful financial wizards, like Warren Buffet, have emphasized profitability for years, and their prowess is corroborated by the Fama/French study referenced above. Corporate profitability provides a company with enviable options, like stock buybacks, that can drive their valuations higher compared to other companies.

For smaller closely-held companies, profitability takes on an even greater level of importance. Smaller companies generally live, eat, and breath cash flow because at a simplistic level, when you can’t pay your bills anymore, you’re out of business. However; business owners get lulled into a sense of security by sustained cash flow and lose sight of the ultimate reward. Many closely-held businesses are not profitable enough to justify the inherent risk of business ownership. If you are a business owner, make sure you are doing everything it takes to be profitable. It’s hard to be profitable. Tough choices must be made regarding employees and other hard costs. It takes a great deal of creativity and hard work to drive revenue in such a competitive world, but profitability is worth the effort. Profits are the ultimate measurement of your success as a business owner, and mathematically justify the many risk factors faced by a small business.

At the family level profitability is a rarely-discussed concept, but is critical to our success as a basic premise of capitalism. Just like small businesses, many families get caught up in cash flow and miss the big picture. We should all ask ourselves this question: “Is my net worth increasing or decreasing?” Net worth is determined by adding everything you own and subtracting everything you owe. We regularly calculate and monitor net worth for our clients, because it tells us if a family’s finances are heading in the right direction. In socialist or communist societies, net worth is of little importance because reward for work is considered part of a collective process, and therefore shared equally with no regard for effort or skill. Not here, thankfully! We work hard, build valuable skills, and are allowed the freedom to determine for ourselves what we do with what we earn.

The real magic of capitalism happens when we take the profits gained at a family level, and invest them back into the loop of private enterprise for even greater profits. The results are astounding as evidenced by the countless success stories of ordinary people who follow this track. But profitability is not easy at the family level, either. Unforeseen expenses and emergencies, overspending, and other risks create a tough environment for profitability in our personal finances. Most families lose sight of the big picture, and fail to realize how important it is to make progress every year towards long term financial goals.

We are fortunate to have have the opportunity to profit from our hard work and the risk we take, whether it’s in the stock market, our own business, or our personal family finances. Combined, these levels of profitability provide opportunities beyond any ever conceived for so many at any time in history. Are you taking advantage of these opportunities? Do you know where you stand with regard to your personal profitability? Now, while collecting end of year financial data, is a great time to answer these questions and implement a plan towards greater success.