Last month and in previous articles, I advanced the idea that your ultimate goal as a business leader is to optimize the business's value over the long term (Cunningham).
Jim CastigliaSince business is about accounting and numbers, you can use ratios to measure your organization's financial progress.
Last month’s essay put forth the first of three key ratio categories (liquidity) and provided three ratios you can use to measure your status. If you haven’t seen or read that article, make sure you do and use that information to see where you stand on liquidity.
This month will feature the second category — profitability ratios. There are two kinds of businesses:
- Non-profit, for example, a charity or private foundation
- For-Profit.
That’s it! For the purposes of this article, I’ll assume you’re a for-profit business that operates with the goal of making a profit and getting a great return on your money and your efforts.
As in last month’s article, I’ll cover an additional three ratios (now totaling six) you can use to measure and control your profitability:
- Rate of return on sales ratio - measures how much operating income was derived from every dollar of sales.
- Rate of return on assets ratio (ROA) - measures the income (profit) generated by the assets of the business
- The rate of return on investment (ROI) measures the return on the owner’s investment. This ratio is also called the return on equity (ROE).
Let’s look closely at each of these ratios.
Rate of Return on Sales
This ratio shows how well you’ve managed your expenses and whether you’re generating enough sales to cover your fixed costs and produce an acceptable profit level. What profit percentage is the average for the finishing industry? This is a reasonable place to start. Grocery stores generate about 1% in profit, but because their sales volume is so high, that is an acceptable level of return/profit. (Whole Foods Market has a profit of about 3%.) Check the finishing and coating industry standards for comparison. Get this ratio from your P & L and divide your operating income by your net sales.
Rate of Return on Assets
This ratio shows the profit that’s generated by the use of business assets. Like the above ratio, this can vary depending on the industry and the required assets. A trucking company will have more assets than an apparel shop. A good ratio shows that management is using the company’s assets effectively. Use your balance sheet and P & L to get this ratio. Divide your income before taxes (P & L) by your total assets (balance sheet). Again, use the finishing industry’s averages as a guideline (but work to exceed those averages).
Rate of Return on Investment
This ratio measures the return on the owner’s investment in the business. A good standard is an ROI of about 15% to fund growth. Otherwise, you may have to go outside to get money since you’re not generating enough cash from operations alone. Get this ratio by dividing the income before taxes (P & L) by net worth (balance sheet). You can divide EBIT (earnings before interest and taxes) by net worth. This will give you a higher percentage since you’re adding interest back to your income.
This ratio is considered one of the best measures of profitability. However, as with all ratios presented, don’t use them alone; use them in conjunction with the others.
Note that there’s a direct relationship between ROI and risk. The more risk, the higher the return should be. Financially speaking, if you’re investing in a riskier asset, it should produce a higher return. Less risk usually means lower returns.
Lastly, consider other factors when analyzing your profitability, like how you price your services and products, your expense structure, and your market share.
Assignment: Figure out these important ratios for your finishing and coating business. Take advantage of your accountant. Make sure your executive team understands liquidity and profitability ratios and what they mean. Next month, I’ll present the third category of ratios, which you can use to measure and control your organization.
Don’t hesitate to call or text me at 949.338.7141 or email me at jvcastiglia@icloud.com if you have any questions.
Jim Castiglia is the founder of Business Street Fighter Consulting and supports entrepreneurial business owners in their desire to grow and maximize the value of their business. He can be reached by email at JimC@BSF.consulting or by phone at 919.263.1256. Visit www.BSF.consulting
