Powerful concept, simple math

(FSB Magazine) -- Is your business generating a true profit? The number tells you how hard the invested capital in your company is working.

There's a dangerous tendency to think invested capital is free, because you don't have to pay for it every month as you would for a bank loan. Not so. True profit factors in what you might earn on that capital in another venture. Fortunately, it's easy to calculate.

First, figure out how much capital is wrapped up in the business. Most companies use two kinds of capital: borrowed money (or debt) and invested money (equity). Both can be put toward anything from raw materials to computers, inventory, even the pens in the supply closet.

Next, figure out your cost of capital - and think like an investor. Historically investors expect to make about six to seven percentage points more on their equity than they would on government bonds, which are considered a safe spot to park money.

Short-term Treasury notes currently pay about 5 percent. So your cost of equity will be about 12 percent. (Add a few percentage points if your business is especially risky.)

Those two numbers get multiplied to figure out your total cost of capital, which you then subtract from net profits. Here's the formula:

[NET OPERATING PROFIT AFTER TAXES] - [CAPITAL × COST OF CAPITAL] = TRUE PROFIT

If your true profit is more than zero, you're earning more than your cost of capital. If it's less than zero, you're not. It's that easy.

Calculator: What's your company's true profit?

How to make a true profit

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