I know, we’re accountants and all we want to talk about is numbers. Maybe. But for good reason. Let’s examine the world around us and see how much numbers dominate our lives:
- When we wake up of a morning most of us are woken by an alarm which is triggered by a clock which measures time in numbers.
- We switch on a radio or television to the station (number) we wish to listen to or watch.
- We drive our car identified by its registration number within a speed limit measured in numbers or we catch public transport identified by its number, the 465 bus or the 7:08 train.
- We use tools during the day which in nearly every occupation are operated, identified or opened by numbers:
- Be it books;
- Or computers;
- Or a piece of 6 by 4;
- A 25 mil length of hose;
- A 50 mil spanner etc., etc.
- And in our leisure time we play sports whose end goal is usually to win by scoring a higher number than the other side.
As you can see it is numbers that underpin most things we do, every day. So shouldn’t we, as business owners, be very concerned about numbers because if they underpin most things we do they must play a very large part in running a successful business.
So what numbers drive a business? There are an array of numbers that can provide you with insight into your business’s performance. This insight will in turn drive your strategies for improving business performance. Let’s look at a Profitability measure and an efficiency measure.
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 dollar is ultimately available for you to draw out of the business or to receive as dividends.
Formula: net profit divided by 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 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 divided by 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. SOURCE NOTE: Bullseye Business Solutions
Very soon we will be announcing a new service of real time online monitoring of some of these important measures of your business.