Whether you want to start a business because you’ve been laid off, you’re trying to supplement your income in today’s economy, or it's a dream you’ve always had—this path can lead to financial independence, but only if you first understand the financial principles that go into building and running a successful business.

As a serial entrepreneur myself, I can tell you first hand that you will achieve far more when you have a strong knowledge of financial literacy, but it’s important to point out that this is more advanced than the topics you learned before I had a solid understanding of the financial topics needed to run a business, my businesses performed poorly compared to the businesses I’ve run since acquiring this knowledge.

This is more important today than at any other time in the last several decades because of the weakness and volatility in our economy. When times are good and money is flowing, it’s a lot easier to overcome business mistakes, but when you’re facing an economic downturn, seemingly small business mistakes can be devastating.

So in this six part series, I will be explaining the financial topics you need to know in order to start and run a successful business, and the first one will be the topic of profit.

So what is profit?

In a nutshell, profit is the money you have leftover after paying your expenses.

To be more precise, gross profit is revenue minus the cost of goods sold (COGS), and net profit is the final profit after deducting all expenses, including COGS, operating expenses, interest, and taxes.

The distinction is subtle, but important because many new entrepreneurs will take the time to calculate the cost to produce their products or services, but will often overlook their other costs until they’re blindsided by insufficient cash flow. When you fail to take all of your costs into account in pricing your products or services, you’ll end up underpricing them, leading to lower profit margins that make you unable to run a sustainable business. On top of that, many of the customers you do acquire early on under this pricing structure, will likely leave when you're forced to raise your prices.

This is why it’s critical to truly understand the industry you’re considering starting a business in so that you can plan an appropriate budget. Keep in mind that different industries have different costs, and even if you’ve worked in that industry for years, you may not know about many of them if you’ve never run a business in that industry before.

I’ve started several businesses in several unrelated industries. I can tell you first hand that it’s incredibly easy to overlook many of the expenses you’ll likely face, and that can lead to financial disaster. In one of these businesses—a boat manufacturer, I was blindsided by several very large expenses that I didn’t expect, but someone with more knowledge of the industry would have. These expenses wiped out every bit of profit the business had generated up to that point. Side note: that business ended up sinking like an anchor and I lost hundreds of thousands of dollars in the process.

This highlights the importance of understanding the industry you’re starting a business in because if you can’t maintain a healthy profit margin, you won’t stay in business very long.

I’ve learned a thing or two about researching an industry by making my own mistakes, but I don’t want you to learn that way because it’s painful and expensive, and it can take years to recover from the financial damage that often comes from a failed business.

A friend recently shared an article that gave me a lot of insight on this issue. The article was an interview with Thomas Carver, who runs a nearly $800 million dollar private equity firm focused on buying and selling businesses. I was intrigued by the fact that his firm, Harren Equity Partners, invests in just a handful of industries so his team can develop a deeper knowledge in those industries to make better decisions, but his approach to acquiring this knowledge, in my opinion, is what was most unique.

“You can’t be a ‘drive by’ investor, and what I mean by that is you have to really understand whatever you’re investing in, and that requires knowledge on a visceral level. It also requires a deep interest, bordering on passion, because this is exactly what it takes to dig deep enough into an industry to see what others miss—that’s how you spot the opportunities and red flags. You have to love what you’re doing to pour through the mountains of research, annual reports, industry trends, and other data needed to make the best decisions for your goals. If you don’t love it, you just won’t do it,” he explained in that interview.

I didn’t have that level of knowledge in the businesses I launched that later failed, and it’s clear that was the primary contributing factor. Producing a healthy, sustainable profit margin requires an in-depth understanding of your industry.

How much profit should you target?

Profit, or more specifically, profit margin, varies dramatically by industry. For example, the financial data industry generally operates at a 70% gross profit margin and a 24% net profit margin, while the grocery store industry operates at a 27% gross profit margin and a 2% net profit margin.

If you’re starting a business in an industry with lower profit margins, you’ll generally need a lot more start-up capital, and you’ll have less room for error. A higher profit margin business can generally be launched with less capital, and since you get to keep a larger portion of your revenue, you can scale it more quickly to generate even greater returns.

And higher margins also tend to make a business more resilient to the natural ups and downs of the market, which can be especially valuable during a volatile economy. 

While there is no black and white answer here, your business should always seek to maximize your profit margins, but keep in mind that this directly impacts your pricing and there’s a delicate balance to make. If your prices are too high, fewer customers will buy from you, so while you may have higher margins, you could end up with lower overall profits.

Start by looking at the average profit margin for the industry you want to start a business in, and use that to calculate how much revenue you’ll need to produce in order to pay yourself what you need to earn. This is your starting point to determine the viability of your business. New York University has a great resource breaking this data down across a range of industries, calculated in a number of ways.

From here, you can adjust your margins up or down to achieve the ideal balance that allows you to run a sustainable business while acquiring new customers as quickly as possible.

But profit isn’t always so black and white

From an accounting perspective, profit is indeed, a simple black and white answer, but in practice, it can be a little more nuanced because of how you treat certain expenses—especialy your own income.

First of all, you’ll be able to categorize some of your personal expenses, like internet, phones, and vehicles as business expenses. These expenses factor against your profit margin, but they’re also expenses that you no longer need to pay out of your W2 income, so this gives you some wiggle room to reduce your profit margins, and subsequently, your prices to make it easier to acquire new customers more quickly. Your personal salary also factors against your profit margin, but it’s going directly into your pocket, minus any necessary taxes, of course.

So it’s a smart idea to work with an experienced accountant, and ideally one who is familiar with your industry, to find the right balance. There is no one size fits all solution here.

Bottom line: profits are the foundation of your business

If you want to build a strong, sustainable business, you need to start by targeting the right profit margin, and that requires a deep understanding of your industry.

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David Bell is a serial entrepreneur, and is currently the CEO of the national workplace drug testing company, USAMDT, where they help employers create a safer and more productive work environment.