As I first mentioned in this Blog two weeks ago, a good financial analysis can lead you directly to the source of most problems within your business. Yet, many small business owners and entrepreneurs don’t spend a lot of time on financial analysis, or only do so superficially. The series of Blog posts on the DuPont Method of analyzing financial performance will give the small business owner and entrepreneur an excellent set of tools to begin doing financial analysis on their business. For a diagram of the DuPoint Method, click here.
Net profit is a good thing, although it should never be confused with positive cash flow (see the Blog It’s Cash That Counts). When your net profit is not where you want it to be, digging deeper into the profitability ratios can help you understand why. Let’s start with Net Profit Margin which shows the percentage of each dollar of sales remaining after all costs and taxes are paid. The Net Profit Margin formula is pretty straightforward:
The key to remember here is that the Net Profit Margin is an indicator of how your business is doing, financially, but it does not tell us much about the details. Underneath Net profit Margin are two other ratios that can lead you to understand why you have the net profit that you do. On the one hand, you have direct expenses that your business incurs to create the product or service that you sell, and on the other hand you have operating expenses that your company incurs to support the production of that product or service. If either one is out of line your bottom line will be affected.
Examples of direct expense could be the cost of materials in manufacturing, or the wholesale price of a product that a company distributes. For a service company, the cost of consultants or other employees that create and provide the service is often the largest direct expense. Operating expense might be rent, utilities, and internal company services such as human resources or accounting. Now, there are eternal arguments on what constitutes a direct or operating expense; I am not going to take that up here because it is really the topic for a dozen other Blog postings!
When we decompose Net Profit Margin into its’ constituent parts we are able to see two things clearly, how well the business is operating and how much tax is paid to the government:
Operating Profit Margin X Tax Rate
I will leave it to the lawyers and accountants to take up tax rates, but Operating Profit Margin is the key to understanding how profitable your company is. The constituent parts of this ratio will reveal to you how well your company is doing both with direct expense and operating expense with this formula:
Operating Profit Margin = Gross Profit Margin X Operating Expense Margin
Gross Profit Margin represents the percentage of each dollar amount that remains after paying for the direct expenses. Its formula is:
Gross Profit Margin represents the percentage of each dollar of sales that remains after paying direct costs for providing goods and services. This ratio will tell you how efficiently your company is at creating products and/or services. Knowing the history of this ratio will be helpful, but even more important is the comparison to you industry. If your company cannot provide equivalent products and services at a similar cost, you will have difficulty competing in the marketplace.
Operating Expense Ratio (sometimes called Selling, General and Administrative expenses, or SG&A) represents the percentage of sales that go to the general operations of the company. The Operating Expense Ratio is calculated as follows:
In effect, there are two areas of a company that drive profitability, the cost of the product or service that the company sells and the cost of general operations to run the company. If either one is larger than it should be company profitability will suffer. Some companies have problems with one or the other, and at times some companies have trouble with both.
Next week, we will introduce activity ratios, and the week after, have a complete example of a financial analyisis, including an spreadsheet that you will be able to use as a model for you own company.