A recent article in the Australian Financial Review explained that the three main reasons for business failures were: Poor Financial Management (28% of failures), poor Accounting (16%) and lack of Management experience (15%).
So Poor Financial Management is the main culprit in business failures. The Directors and the owners of a company need to monitor the financial performance of the business. Revenue, Gross Profit, Operating Profit are important elements, but they have limitations: Firstly, they vary considerably with the ups and downs of Revenue (seasonality), and secondly, an increase in Operating Profit does not always reflect good performance (if Operating Profit increases by 5% for example, while Revenue increases by 20%, it is a poor result).
Ratios do not have these limitations and that is why they are widely used to measure financial performance.
Let’s look at the first set of financial ratios: The Profitability Ratios.
Profitability ratios measure the business’ ability to generate profit as compared to its costs and expenses, over a period of time.
They are: The Gross Profit Ratio, the Operating Profit Ratio and the Profit Before Tax Ratio.
They are calculated as follow:
- Gross Profit Ratio = Gross Profit / Revenue x 100
- The Operating Profit Ratio = Operating Profit / Revenue x 100
- The Profit Before Tax Ratio = Profit Before Tax / Revenue x 100
These ratios are more valid measures than the pure $ amounts, because they show trends and are usually far less impacted by seasonality. They need to be compared to the previous period, and the same period of the previous year.
If these ratios are improving, the business is improving its financial performance and will generate more profits, even if Revenue remains flat.
If these ratios are flat, the business is consolidating its financial performance and higher Revenue will generate higher profit. But lower Revenue will generate lower profit.
If the ratios decrease, then the financial performance is deteriorating and actions need to be taken to understand the problem, take measures and reverse the trend.
Apart from serving as indicators (Green, orange or red light), these ratios are also very useful to do a Profit & Loss budget. If your Gross Profit Ratio is 56%, you will need $1.8 million of additional Revenue to generate $1 million of additional Gross Profit.
It is also important to keep in mind that these ratios vary from one industry sector to the next, so if you want to benchmark your business versus others, it is important to compare with businesses in the same industry sector.