Do you know your business’s profitability ratios?

Profitability ratios compare your business’s profits to sales, total assets, or net worth. They’re a great business tool for analysing your business’s performance.

Profitability ratios allow you to measure your business’s performance both “against itself”, and against your competitors and other similar-sized businesses in your industry.

The data they provide can also be used as a tool to improve your business’s profitability.

With such awesome benefits, if you don’t know your business’s profitability ratios, it may be time you discovered them.

Analysing Your Business’s Performance

Once you have established your current profitability ratios, you can compare your business’s present performance with its performance in past periods. You can also use the ratios to benchmark your business against other businesses of a similar size in your industry.

Generally speaking, if your ratios are higher than a previous period, or than the industry benchmark, you can be confident that your business is performing well.

However, profitability ratios aren’t just useful for making static comparisons.

Improving Your Business’s Profitability

Profitability ratios are also a great tool for improving your business’s profitability. By analysing your profitability ratios to discover the different factors that affect them, you can set target ratios that are tailored to your business’s unique circumstances.

Target ratios can be used to bring your business in line with industry benchmarks, or even exceed them. As you work to achieve these target ratios, your business’s profitability will also increase.

Setting Target Ratios

Target ratios very from industry to industry, and even from business to business. So it’s important to consult with a professional bookkeeper with management accounting qualifications to ensure your target ratios are appropriately tailored to your business and its circumstances and needs.

To set target ratios for your business, it’s important to analyse and identify the factors that drive your business’s profitability ratios. These factors may be internal, or external. For instance, a café with an inventory that’s regularly overstocked may discover that they lose money on food items that reach their use-by date before being sold. A relevant and effective target ratio this business could set would be to lower the volume of stock they waste. Such a measure would in turn increase their profitability.

Measuring Target Ratios

Your target ratios will often be designed in a similar manner to key performance indicators (KPIs) in the sense that your target ratios must be measurable.

In the example above about the café with out of date stock, a suitable target ratio may be expressed as “reduce stock waste by 20%”. This is an easily measurable target, so long as the café has effective inventory management in place.

However, some profitability ratios may require more analysis before a suitably measurable target ratio can be set. For example, a professional services business that offers services on a fixed fee arrangement may determine that they need to lower the costs of providing these fixed fee services. Yet what they can change to lower these costs, and how will they measure these changes?

In this example, the business may determine that the costs of providing their services are determined by the following three factors: time spent delivering the service, third-party costs for delivering the service, and the percentage of total admin costs required to deliver the service. Of all these factors, the easiest to measure and improve would be the time spent delivering the service. This could be done by recording time, and could be expressed as “decrease time spent delivering service X by 10%”.

Fine-Tuning Your Targets

Once you’ve implemented your target ratios and begun to measure your progress, it’s necessary to review and analyse the data to determine whether your goals are realistic. It’s also important to review whether your new processes and controls have a positive impact on your business’s profitability ratios. If they are realistic and having a positive impact, keep it up. If not, you need to identify why, and decide what needs to change.

profitability ratios infographic

Common Profitability Ratios

“Return on investment”, “gross profit margin”, and “return on sales” are all commonly used profitability ratios you’re probably familiar with. Others include “return on equity”, “net profit margin”, and “return on capital employed”. Each of these profitability ratios compares your business’s profits to different aspects of your business, including production costs, investments, and revenue. An EzyAccounts bookkeeper can advise you on which of these profitability ratios are most relevant to your business and its performance.

Your Business’s Ratios

Do you want to discover what your business’s current profitability ratios are? Would you like to use profitability ratios to develop target ratios for improving your business?

At EzyAccounts, we have years of experience assisting business owners with profitability and target ratios. If you would like to learn more about how we can help your business, call us today on 1300 313 397.