If you have missed any of the first four mistakes businesses make during a crisis, you can read about them here: Understanding Your Industry Cycle (M1), Timing (M2), Risk (M3) and Liquidity (M4).
Today we move on to Mistake #5 (M5): Lacking the understanding of your business model’s financial ratios and how they measure-up against your industry.
Why is this important? Because your business model can make or break your company. Properly understanding your model can help you manage more effectively, alert you to potential threats, help you take advantage of market opportunities, and masterfully navigate any economic cycle.
Looking closely at your financial ratios allows you to analyze your company’s financial health, identify how it might be improved and recognize and adapt to trends. These seemingly arcane numbers enable you to gauge the strength, profitability, efficiency, and quality of your business. They make it possible to compare different aspects of your operations and how you stack up in your industry or region. Ratios also provide valuable information regarding the financial sustainability of your company.
The following table provides a sample company’s financial ratio performance compared to its peers. These are some of the more common financial ratios (see Appendix A below) used by business owners, lenders, and investors:
To illustrate the importance of understanding these ratios, we examine the Gross Profit Margin and Net Profitability (Profit) Margin in more detail:
Gross Profit Margin ratio (GPM). The gross profit margin indicates the performance of a company’s sales and production (or an individual product or service). A higher or lower gross profit margin reveals how efficient a company’s processes are in providing the product or service.
The GPM is important because this is the amount of available cash to pay the business operating costs (e.g. personnel, utilities, insurance, etc.). It is essential to ensure your company is operating at or above the industry average, as each industry operates within acceptable levels.
In the sample above, the overall industry operates at a 36% gross profit margin, whereas the client organization operates at 42%. Thus, there is strong indication that the cost structure or the pricing model (or both) are more efficient than competitors or that the company can charge a premium for its products. Conversely, if the company’s profit margin was 25% and its peers operate at 36%, it may be possible for that business to increase its prices. Additionally, the business might leverage technology or find other ways to reduce costs to capture market share due to their lower price structure.
If your business is below the industry benchmark, there are two general reasons why: 1) shrinking revenue relative to sales volume or 2) higher costs.
Shrinking revenue due to lower sales volume does not in and of itself affect your GPM – lower price point does. Some of the reason’s businesses experience a reduction in GPM include excess inventory discounts or increased competition and market penetration strategy (i.e. deliberately lowering price temporarily to gain market-share or build a customer base).
Higher Costs include any costs incorporated in your cost of goods calculation, such as materials, production costs, per-unit product costs, shipping fees and packaging etc. Some companies also allocate a portion of their overhead expenses to cost of sales, which can alter the comparisons. Those cost increases that cannot be passed on to buyers by increasing price will reduce the business’s GPM.
A declining GPM is problematic because it signals a reduction in cash available to cover operating expenses and invest in future business assets. As mentioned above, a higher GPM provides a larger profit base from which all other operating expenses, as well as cash reserves for future investments, originate.
Net Profit Margin ratio (NPM). Over time, the NPM is one of the more important barometers of financial health because it measures how many cents of profit the company is generating for every dollar it sells (i.e. the money that the business has left after expenses are deducted from gross profit). The higher the NPM – the better.
NPM has a direct effect on capital reserves, which means the higher the NPM, the more likely the business will be able to remain resilient in periods of unexpected losses, such as a recession (or an unexpected pandemic) and the more resources it will have available to invest in future growth.
There are several ways to improve a company’s NPM, including:
- Reducing overhead expenses;
- Improving efficiencies in business processes and systems;
- Increasing sales volumes so fixed costs are spread over a larger revenue base, therefore improving profitability percentages; and
- Identifying new markets and/or product offerings to grow sales.
Having a firm grasp of the basic financial framework of your organization today will enable you to make the right decisions – at the right time – to achieve the outcome you desire in the future.
Here are some questions to help determine the current health of your company and provide insight on where operational improvements are needed:
- For every $1 of revenue that is generated today, what are the industry’s financial ratios? Now compare that answer with your current operating performance.
- If your ratios are out-of-line with the industry, what additional changes must be made to bring those ratios back in line with your plans and your industry group?
- Is there sufficient cash to invest in the business to ensure a more sustainable future and to take advantage of opportunities in the marketplace (as discussed in M4 – Liquidity). What level is sufficient?
- What percentage of your people, and your overall cost, go into general running the business; and what volume of business do you need to generate to be profitable?
- What are the company’s profit margins?
Financial ratios alone do not give a business owner all the information necessary for decision making, however; the message of M5 is understanding your financial ratios and ensuring they are consistent with or accel against your industry in the current economic climate.
If you need help understanding your financial ratios and how they compare to your peers, please reach out to us for your complementary industry report. See a Sample Industry Report to see what you would get.
Our next brief Mistake #6: is all about Boom Packaging.
Appendix A Financial Ratios image