Ask any business owner why they are in business, and at least part of their answer is bound to include the following three words – to make money. So, how does a business know if it is making money? Do they wait until their annual visit to the accountant at the end of financial year to find out? Well, it would be a bit late then to discover the answer is no…
That is why it is wise to review business performance on a regular basis. One good way to do this is to use ‘Ratio Analysis’. Over the next two months, I will explain and examine the different ratios that businesses can use. For my first month of Ratios, I will turn my attention to two ratios – Gross Profit Ratio and Net Profit Ratio – that can be computed month to month or quarterly to track a business’s performance and health.
RATIO #1: Gross Profit Ratio
Gross Profit / Sales (e.g. $299,237/$539,970 = 55%)
This ratio tests the adequacy of a business at making a profit at a trading level by showing the level of profit margin for every dollar of sales made. For instance, in the example figures above, the business would make 55 cents gross profit (that is profit before business expenses) for every $1 sold.
Now, that 55% ratio only tells us so much on its own. The ratio becomes more significant when compared to a previous period, such as the same ratio last quarter or last month. If the ratio increases or decreases, the business then needs to figure out why.
An increase in the ratio for the period may indicate any one or combination of the following:
- Selling prices have risen without corresponding increases in costs.
- Costs have been reduced.
- The opening value of stock has been understated or the closing stock value overstated.
- Purchase invoices have not been recorded for stock already entered.
Meanwhile, a decrease in the ratio will suggest some of the following:
- Costs have increased but selling prices have remained unchanged.
- Selling prices have reduced but costs have stayed the same.
- Inventory has been understated at the end of the period, perhaps due to incorrect values or missing stock.
RATIO #2. Net Profit Ratio
Net Profit / Sales (e.g. $54,549/$539,970 = 10%)
While the Gross Profit Ratio shows the amount earned before business expense, the Net Profit Ratio figures the percentage after all normal expenses have been accounted for. So, in the example figures above, for every $1 of goods sold, a business pockets 10 cents of pure, net profit.
Like the Gross Profit Ratio, this figure is most useful in comparison to figures from previous months or quarters. If there is a change over time in the Net Profit Ratio, but not a significant change in Gross Profit Ratio, this suggests the business has seen a change in its operating expenses. If the Net Profit Ratio is increasing, that suggests business expenses have fallen. Conversely, a decrease in the Net Profit Ratio would point to a rise in business expenses.
If significant differences are found in using the above ratios, a business would investigate the expenses for the periods and perform ‘Expense Ratios’, but that’s a topic for next month…
Jan Wrack is a MYOB certified consultant with Millbrook Accounting Software Solutions. Information provided in this article should not be relied on as a substitute for seeking professional advice relevant to your circumstances.
