Did you know that one way you can improve your business’s profitability is by using profitability ratios and target ratios?
Here’s how it works.
Profitability ratios allow you to analyse your business’s performance by comparing your profit to sales, total assets, or net worth.
Commonly used profitability ratios you are probably familiar with include “return on investment”, “gross profit margin”, and “return on sales”.
Profitability ratios tell you how your business is performing. They can be used to compare your business’s current situation to its performance in past periods, or to benchmark your business against similarly-sized businesses in your industry.
As a general rule, having a higher ratio from a previous period, or in comparison to industry benchmarks, indicates that your business is performing well.
If you’ve identified your business’s profitability ratios, and compared them to those of previous periods and/or those in comparable businesses in your industry, you may choose to use this data to set target ratios.
As the name suggests, target ratios are the target profitability ratios you set as goals for your business. Used correctly, target ratios can help to drive your business’s profitability to bring it into line with industry benchmarks, or even exceed them.
Driving Your Profitability With Target Ratios
There is no one-size-fits-all approach to setting target ratios to drive your business’s profitability. These targets vary from sector to sector, and from business to business.
In order to effectively set target ratios, you need to develop a strategic awareness of what drives your business’s profit ratios, both internally and externally. For instance, in a hospitality business such as a cafe, you may find that your inventory is over-stocked, and you are losing money on items that are going out of date before they can be sold. You may set target ratios to lower the amount of wasted stock, therefore increasing your profitability.
Measuring Your Target Ratios
Once you’ve identified what drives your profit ratios, you need to monitor and amend your processes and controls to address this. This will usually involve setting, implementing, and fine-tuning key performance indicators (KPIs) to drive your business’s profitability.
As with all KPIs and targets, once you’ve set them, you need to find the best way to measure them.
For example, if your business works on a fixed fee arrangement, you may have identified lowering the costs of providing this fixed fee service as one of your target ratios. Now you need to determine how to do this, and how you’ll measure your progress.
In this example, you may consider measuring and addressing:
• The time each of your employees spends delivering this service
• The third party costs necessary for you to deliver this service
• The level of “write downs” on each job
• The percentage of total administration costs apportioned to each job
Of all these factors, the easiest to measure and improve would be time spent on each job. By using an effective time recording system to measure this, you would most likely see improvements, as practices that record 100% of professional time are generally more likely to capture all billable time.
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. If they are realistic, keep it up. If not, you need to identify why, and decide what needs to change.
If you’re using time recording, for example, how does your predicted time spent to complete a job compare with the actual time spent? What does the hourly rate equate to? What is the hourly market rate? If your staff are working hard and yet the actual time spent is longer than predicted, pushing you below the hourly rate, it may be time to consider increasing your rates.
Once you’ve implemented and fine-tuned your target ratios, you’ll then be able to review whether your new processes and controls have had a positive impact on your business’s profitability ratios. If they have, you can look for further opportunities to amend and fine-tune them for maximum benefit.
Your Business’s Ratios
Do you know what your business’s profitability ratios are? Would you like assistance identifying them, and setting, measuring, and fine-tuning target ratios to improve them?
To learn more about how you can use ratios to improve your business’s profitability, speak to your EzyAccounts bookkeeper today by calling 1300 313 397.