Understanding Financial Ratios

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The moment someone starts mentioning phrases such as Return on Investment, Return on Sales, Gross Profit Margins and Financial Ratios, the average person who is not an accountant starts to break into a sweat and heart rates rise. Fear not! These are actually just accountant-speak for common sense analysis of how well your business is doing.

Any investor, banker or potential buyer of your business will seek to understand the financial well-being of the business. Various measurements are used to produce financial ratios which tell the story of growth as against industry norms. If your business is showing a poorer profit margin ratio than your competitors then this is naturally a concern for you and your investors. Tracking performance by these ratios allows the owner to make adjustments in either business expenditure or the sales plan to enhance performance.

Profit is what business is all about otherwise it’s simply a hobby. It makes sense therefore that we pay close attention to profitability ratios. Profit is what is left after all costs and expenses have been deducted. It can be divided into gross profit (simplistically put, sales minus the cost of stock and related expenses) and net profit (the amount left after cost of goods sold and all operating expenses have been deducted).

Example:

Sales:                             R500 000

Cost goods sold:            R300 000

Operating expenses:      R150 000

Sales – Costs of Goods = Gross Profit (R500 000 – R300 000 = R200 000)

Gross Profit – Operating Expenses = Net Profit (R200 000 – R150 000 = R50 000)

Typically, a service provider will have close to a 100% gross profit percentage because there is little or no stock, whereas a retailer would have a far lower percentage. Net profit percentage can be improved if the running costs of the business are tightly managed.

Other Ratios that are commonly used are ROA, ROE and Breakeven

Return on Assets (ROA) shows how the assets of the company are being used to generate profits. This is crucial in determining whether or not expenditure on bigger machinery or premises is justified. No guideline exists for what a return on assets ratio should be, however, the return on assets should exceed the capital charges on the assets.

Net profit                            X 100  

Average total assets                                      

Return on Equity reflects the profit earned per each Rand invested in the business. The higher this ratio the better, as it shows a healthy return for investors.

Net profit                            X 100

Equity

The Breakeven Ratio is the one that many new business owners focus on the most. At which point does the business stop being a financial millstone around the neck and actually starts to make a profit. To ascertain this magical point, divide the Operating expenses by the Gross Profit Margin.

If figures are not your thing, consult a professional or for more information, refer to The Essential Guide for Small-Business Owners, Nedbank, pp39-43

 

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  • The key questions around understanding profitability ratios are: 1. Is your business making a profit? 2. Is the profit ratio comparable to or better than your competitors? 3. Are your investors seeing a healthy return on investment? What profitability ratios do you typically use and how have you used this information to improve profitability in your business?
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