As earnings season cycles around again, publicly traded companies will release results for the 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-2s 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; 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 the measure of its 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 breathe 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 - their expenses simply continue to outweigh total revenue no matter how much they receive in earnings. If you are a business owner, make sure you are doing everything it takes to be earning a profit - maintaining a balance sheet, tracking the cost of goods, and overall managing expenses as much as possible are simple ways to begin.
It’s hard to be profitable. Tough choices must be made regarding employees, investors, and other closely related hard costs. It takes a great deal of creativity and hard work to drive revenue in such a competitive world, but increasing profitability is worth the effort. Profits are the ultimate measurement of your company's ability to succeed, and they greatly help to 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 success as a basic premise of capitalism. Profit margins are really what matter, but 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 (net income, real estate, investments, etc.) and subtracting everything you owe. We regularly calculate and monitor the net worth of 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 the 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. Here, a high net profit means a lot!
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, fail to realize how important it is to make progress every year toward long-term financial goals, and sadly pay in the long run. Focusing on future profitability can be difficult in the day-to-day, but it can do wonders for a family's financial health.
We are fortunate to have the opportunity to profit from our hard work and the risk we take, whether it’s in the stock market, our own business/industry, or our personal family finances. Combined, these levels of profitability provide opportunities beyond any ever conceived 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 for greater success in the future.
These are our thoughts, have a great Thursday.
~ Rob Schulz, CFP
Resource Cited: https://www.sciencedirect.com/science/article/abs/pii/S0304405X14002323
