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. Read more