In this final article on ratio analysis we look at profitability ratios. Profitability ratios are probably the most important indicators of your business’ financial success. They reveal both its actual performance and its growth potential. No doubt all business owners are familiar with some of these, such as gross and net profit margin, but others, such as Return On Equity, can give you an entirely new perspective on your business.
Net Profit Margin: shows you the bottom line on profitability – how much of each sales pound is ultimately available for you to draw out of the business or to receive as dividends.
Formula: net profit / turnover
Reference to industry norms will provide a baseline for gauging if your profit margin is adequate. Analysed over time, the year-to-year variations may be due to abnormal conditions or expenses. Variations may also indicate cost blowouts which need to be addressed.
A decline in the ratio over time could be indicative of a margin squeeze suggesting that productivity improvements need to be initiated. In some cases the costs of such improvements may lead to a further drop in the ratio or even losses before increased profitability is achieved.
Return On Assets: indicates how well your business is using its assets to produce more income by relating how much profit (before interest and income tax) the business earned to the total capital used to make that profit.
Formula: net income / total assets
The ratio can be used on an annual basis to compare your business’ performance to that of firms in a similar line of work. A low ratio in comparison with industry averages indicates an inefficient use of business assets. A high ROA, indicating high return on investment in assets, can be attributable to high profit margins, a rapid turnover of assets, or a combination of both.
Return On Equity Ratio (ROE): also known as Return On Investment (ROI) it shows you what you’ve earned on your investment in the business over the accounting period.
Formula: net income / owner’s equity
In short, this ratio tells the owner whether or not all the effort put into the business has been worthwhile. All other things being equal, the higher the ROE the better the company and the more value you are getting from the effort you are putting into running it.
You can compare your business’ ROE to what you might have earned on the stock market or a bank savings account during the same period. Over time your business should be generating at least the same return that you could earn in these more passive, relatively risk free investments. Otherwise, why are you spending your time, trouble, and capital on it? Would you be better off selling up, putting the money into a savings instrument and avoiding the daily struggles of small business management? The alternative is to work at improving ROE through developing a clear strategic plan for growing the business.
The bottom line on your income statement is not the only important figure on it. It may not even be the most significant. Ratio analysis provides a whole extra dimension of valuable information obtainable from the data in your statements that can be used to evaluate your company’s performance, its current status, and its evolution over time by monitoring progress against predetermined internal goals (as in your strategic plan) or by checking on how you measure up against competitors and the industry overall.
Ratio analysis is a proven way of identifying problems in a business. The information they reveal can be used by owners to make the right decisions for improving operations and building a stronger and more successful business.
Davies McLennon are Stockport Accountants