The good news is that your accountant has prepared last year's financial statements depicting your business’ performance and it reveals a profit. But what does profit and profitability mean for your business performance?
It is easy to misconstrue profit for profitability. To understand and position your business correctly, it is crucial to understand the difference.
The difference between Profit & Profitability
Profit is an absolute figure, determined by subtracting total expenses from the total revenue. Profitability, however, is a relative measure, determining the scope of a company’s profit in relation to the size of the business. This is primarily measured through two types of ratios; margin and return ratios as we see below.
Simply because a business earns a strong nominal profit, does not mean it is highly "profitable". Many business owners expect that increasing profitability is solely related to the level of sales or general activity.
Before we get started, let's look at some ways of measuring profit performance.
Ratios for Profitability & Margins
Profitability ratios assist to put these considerations into tangible, traceable figures that a business can take and use to track progress. With your financial statements in place and readily available, these ratios are easy to calculate on an ongoing basis when conducting business reviews.
Business objectives should be based on ratios, permitting you to track progress in relative terms over the financial year.
Gross Profit Margin
Gross Profit Margin divides Gross Profit (Sales less Cost of Sales) by Sales Revenue.
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High margin = higher efficiency of core operations, covering major expenses whilst still providing earnings to the business
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Low margin = can be reflective of industry, higher sales volumes or hide some inefficiencies.
Operating Profit Margin
Calculated as Earnings before Interests & Taxes divided by Revenue. It is often used to compare performance across the business' industry.
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High margin = the business may be better equipped to cover fixed costs and interest on obligations, and support future growth.
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Low margin = Can be reflective of cost overhang or gross margin performance.
Net Profit Margin
Calculated as Net Profit after Taxation divided by Revenue.
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Benefit: all items, including tax, are considered
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Detriment: one off taxes and outliers are also calculated, potentially skewing data from quarter to quarter.
Let's take a look at an example.
This trading business has been undergoing very strong growth in its sales over a three year period. While impressive, a closer look at the ratios revealed the following:
A look at the key ratios, shows us that despite the nominal growth, the key Profitability Ratios are declining (as shown in red above). This means the business is working a lot harder to deliver very similar results.
This is not an uncommon story. As business seek growth, this can be accepting lower sales margins, more fixed cost or just working harder and stretching unused capacity.
Reading the Ratios & Taking Action
In this example, the business has identified the decline and has a set a goal to arrest the declining trends.
One excellent analytical tool is to look at what is called the "Power of One"^ 
This uses a 1% change in key profit drivers to see the potential impact on Profitability. In this example, the business could see that:
- A price increase has a better impact on Profitability than more sales volume.
- A Cost of Goods reduction is stronger impact than Overheads.
If the price increases by 1% or more, how many clients can the business afford to lose while staying profitable? What if clients are retained, and you are required to increase expenses to maintain demand?
With further analysis, it was confirmed that the business had not had a price increase for some time, and that its customer service was strong. A price rise of 3% was agreed.
More information?
E: enquiry@mcpgroup.com.au
P: (03) 9620 2001
W: www.mcpfinancial.com.au
^ Power of One – extract from Cash Flow Story. www.mycashflowstory.com