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What are your financials telling you?

Updated: Jul 4, 2021


Sitting back away from the day-to-day demands of your business, and regularly evaluating its performance is good practice. More than ever in these unprecedented times, it is critical to ensure business recovery and continuity.


A good starting point for reviewing your business’ performance is to start with reviewing your financials, and in particular your profit. Reviewing your financials can give you insights into the functioning of your business.


Profit is the goal of every business, but how do we track the profitability of a business, and how do we know what a good profit is?


Profitability ratios are the answer to both questions.


Profitability ratios can provide insights into a business’ efficiency, particularly management’s control of costs.


What are the Three Profitability Ratios?


There are 3 profitability ratios you can calculate for your business — gross, operating and net.


As we explore the different profitability margins, you will see that each margin peels away a layer of costs associated with the operations of a business such as taxes, cost of goods sold, interest payments, and so on. All of which have a direct bearing on the profitability of a business. If the business is unable to control those costs, it will not be profitable in the long run, regardless of the amount of revenue it generates, the business will never be able to overcome the increased costs and will remain unprofitable.


Gross Profit Margin


The gross profit margin measures gross profit compared to sales revenue. The margin tells us how much profit a business is making, taking into account the different costs needed to produce the goods or services the business delivers.


The higher gross profit margin tells us that the business is operating at a higher level of efficiency in relation to its core operations. Items reflected by this efficiency are the ability to cover the both the direct (ie costs attributed to producing the goods or services) and indirect (ie costs attributed to accounting fees, advertising, insurances, interest, legal fees, labour burden, rent, repairs, supplies, taxes, telephone bills, travel expenditures, and utilities) costs of the business.


A low gross profit margin tells us that the business has a high cost of goods sold, which can tell us that they have poor buying, high labour, low selling prices, low sales, or formidable competition in their niche.


Definition

Gross profit margin, or gross margin, is a business’ sales revenue minus its cost of goods sold (COGS). In other words, it is the sales revenue a business retains after incurring the direct costs associated with producing the goods or services the business delivers.


With the introduction of grants and subsidies from the government, the sales revenue should not be included in these numbers.


Calculation

Gross Profit Margin = ((Sales Revenue – COGS ) / Sales Revenue )) x 100


As a guide, Gross Profit Margins should be greater than 30%. For industry comparisons, my suggestion is you review Benchmarks by industry | Australian Taxation Office (ato.gov.au).


Operating Profit Margin


The operating profit margin measures operating profit compared to sales revenue. The margin tells us how much profit a business is making, taking into account the different costs needed to produce the goods or services the business delivers, and the ongoing operating costs of the business.


Definition

Operating profit margin, or operating margin, shows how much money is left after deducting operating expenses from your gross profit. This ratio is the percentage of sales dollars left after subtracting the cost of sales and all indirect costs (or overheads) - accounting fees, advertising, insurances, interest, legal fees, labour burden, rent, repairs, supplies, taxes, telephone bills, travel expenditures, and utilities.


With the introduction of grants and subsidies from the government, the sales revenue should not be included in these numbers.


Expense items like depreciation as they are not operating expenses should be included in net expenses.


Calculation

Operating Profit Margin = ((Sales Revenue – Operating Expenses ) / Sales Revenue )) x 100


For industry comparisons, my suggestion is you review Benchmarks by industry | Australian Taxation Office (ato.gov.au), particularly those for the key contributors to operating expenses – Wages and Rent.


Net Profit Margin


The net profit margin, also known as the bottom line or the earnings of the business, is the result of all revenues and expenses that are required to operate the business – both direct and indirect costs. When all these costs have been accounted for, the resulting number is the total earned by the business for the quarter or year.


In the current climate, if there are grants and subsidies (eg: JobKeeper), these should be added to the revenues at this stage.


The net profit margin is the relationship between net income and the total revenue of the business.


Definition

The net profit margin, measured as a percentage is also known as net margin, indicates how much net income a business makes with total sales (including any grants / subsidies) achieved.


Your net profit margin shows how much money is left for distribution to the owners of the business.


With the introduction of grants and subsidies from the government, any such income should be included in net revenue numbers.


Expense items like depreciation as they are not operating expenses should be included in net expenses.


Calculation

Net Profit Margin = (( Gross Margin – Overheads) / Net Revenue ) x 100

Case Study 1

The owner of a Plumbing business with 15 permanent plumbers providing facilities management services to the manufacturing industry, had a question: ‘why am I not making any money when my team are working flat chat?’.


My starting point was looking at the 2 margins.

· Gross Margin – 18%

· Operating Profit Margin – 1.2%


Gross Margin was far less than the guideline of 30%. Additionally, when I looked at the utilisation of the team I was able to confirm it was 90% - they indeed were working flat chat!


Upon further inspection, the lower than expected Gross Margin identified there was a pricing issue. The hourly rates presented to clients while it included the cost of the plumbers plus a margin, they did not include all the costs of the plumbers – salaries, cars, mobile phones, etc.


Upon surveying the market, it was identified that the rates were at least 10% lower than its competitors due to this issue. Unfortunately, it is not easy to change your rates over night, so a plan was put in place to increase rates over a 12 month period, supported by an ongoing review of the market.

Case Study 2

The owner of a hospitality business, had a question: ‘why am I not making any money?’.


My starting point was looking at the 2 margins.

· Gross Margin – 70%

· Operating Profit Margin – a loss


Gross Margin was in line with the guideline of 30% as a minimum. However, when I looked at the Operating Expenses, Rent was a significant cost far exceeding the benchmarks provided by the ATO.


The owner went back to her landlord and was able to negotiate a 50% reduction in rent, enabling the business to increase their future Operating Profit Margin to greater than 10%.

Final Thoughts

When analysing any business, yours or someone elses, we gather clues and put them together in a story that helps us determine the overall health and strength of the business.

Using profitability margins like gross profit, operating profit and net profit help us identify clues for further investigation and drill down, then enabling us to identify areas for improvement.


Rod is a business advisor providing smaller businesses with the necessary skills and processes to deliver their business improvement and turnaround initiatives in the role of advisor and delivery manager. In particular, based on 30 years advising and delivering large and small enterprises on technology projects, Rod has provided guidance and support to businesses on how to use technology to grow or to support the scaling of businesses. For more information refer to www.transcendhcs.com.au.

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