Milton Friedman, the American economist and Nobel Memorial prize winner for Economics had said, “The most important single central fact about a free market is that no exchange takes place unless both parties benefit.” So, while I may be drawing a salary as an employee, I have to render services to my employer for that salary. If I am a consultant, I will barter my expertise for a fee. If I am in the business of business, I have to make products or render services to my customers. Only then can I justify the profits as my earnings. It is this profit which, beyond sustenance, provides for growth of the business, helps counter competition in the marketplace, provides for contingencies, etc. Hence, the concept of ‘maximizing’ profit.

So when ‘profitability’ has to be sustained, all profit-making entities must standardize and benchmark ‘profitability’ first. The ‘standardization’ is for the purpose of a common and clear understanding of profit in the context of a given business entity. The ‘benchmarking’ is to gauge performance in the marketplace.

A profitability index, also referred to as a profit investment ratio or a value investment ratio, is a method for discerning the relationship between the costs and benefits of investing in a project. Many companies and investors use the profitabilityindexas a way of ranking a group of potential projects.

Broadly, there are several commonly used and important Profitability Ratios including:

Gross Profit Margin is gross profit as a percentage of sales revenue.
i.e., (Revenue- Cost of Sales)/ Revenue
Cost of Sales includes variable costs and fixed costs directly linked to sale such as material and labor for a manufacturer. It does not include indirect fixed costs like office expenses, rent, etc. Hence, higher gross margins show greater efficiency in turning raw materials into income.

For a retailer, on the other hand, it is the markup over wholesale. Hence, retailers can measure their profit by using two basic methods, markup and margin. A markup is the percentage of profit as a retailer’s cost for the product. The margin reflects profit as a percentage of the retailer’s sales price for the product. Both yield different results but are valid descriptions of the retailer’s profit.

Operating Margin is the ratio of operating income divided by net sales. Operating income is the difference between operating revenues and operating expenses. This is also called Earnings before Interest and Taxes (EBIT or Sales) or operating profit. Thus, it is a measure of the revenue surplus before taxes and other indirect costs like rent, interest, etc. Essentially, a good operating margin is required to provide for fixed costs like interest on debt, etc.

Net Profit Margin or Return on Sales indicates profitability after all costs have been accounted for.
i.e., Net Profit Margin = Net Profit (After Taxes) / Revenue
A low profit margin indicates a higher risk that a decline in sales will lead to net loss. It is also an indicator of a company’s pricing policy and the ability to control costs.

However, the business entity’s financing and operating arrangements have to be taken into account first. To overcome the potential confusions created by these considerations, FINTEL uses a measure called Return on Asset Investment. It is calculated using earnings before interest and taxes and provides a direct measure of the earnings ability of the company. The earnings ability is related to the investment in assets using both debt and equity. The ROAI calculation allows you to see whether an adequate return is being earned on the assets that have been purchased for use in your business regardless of the amount of debt that is carried by the firm.

There are a host of other profitability ratios like Return on Equity (ROE), Rate of Return (ROI), Return on Assets (ROA), and others. All these measurements have their own unique applications and usefulness but they function like an eagle’s eye on your business. Rather than go into the specifics of these ratios theoretically, it is better to identify the ratios appropriate for your business and purpose initially.

FINTEL (www.fintel.us) provides the financial intelligence needed to make sense of the various profitability performance situations including in light of the relevant industry. So, whether you are viewing it from an investment perspective or to study a particular industry, you can get an insight into the financial profiles and performance of privately-held companies.Or,you may just want to check out the profitability quotient of your company.

It is imperative for a business owner to be ‘on top of things’ and constantly evaluate the performance of the business, irrespective of the size of the business – it could be a small printing business or a mammoth multi-product conglomerate. Business performance, though it may seem great in absolute terms, always has subjectivity involved and it is crucial to compare it industry competitors & established industry benchmarks. It is here that financial ratio analysis comes in handy.
The purpose of this post is to introduce the subject of financial analysis to small businesses, entrepreneurs and young managers, especially the significance of financial ratios.

What is financial ratio analysis?

Financial ratio analysis is the selection, evaluation and interpretation of financial data in easier to understand ratios, which have been identified as critical indicators of financial performance of the business and can be used for strategy and decision-making. Financial ratio analysis is popularly used to compare a firm’s financial performance over a period of time (trend analysis) or to assess performance in comparison to other businesses.

Categories of financial ratios

Financial ratios can be grouped into categories which highlight the various facets of a firm’s financial health and operational efficiency. Some of the categories of ratios are given below:

• Leverage Ratios disclose to what extent debt is used in a firm’s capital structure.
• Liquidity Ratios present a firm’s short term financial situation or solvency.
• Operational Ratios present a firm’s operational efficiency & asset utilization.
• Profitability Ratios indicate the return on sales and capital employed.
• Solvency Ratios measure a firm’s ability to generate cash flow and honor its financial obligations.

In our next post, we’ll take up Leverage Ratios in more detail.