Financial Ratios – the basics

 

 

 

 

How often do you hear the terms margin and mark-up used in business? While most business people understand that these financial ratios relate to profits, how many of them understand the calculation behind them and what they really mean?

Let’s briefly look at a few of the key financial ratios that are likely to be important in the daily running of your business, how they are calculated and what they mean to your business.

Gross Margin

Gross Margin is the amount of gross profit being made expressed as a percentage of revenue. (Gross profit relates to profit directly from the sale of goods before considering any running costs of the business such as rent, electricity & indirect wages).

Example:
Sales (a)	$10,000
Cost of Goods Sold (b)	$7,000
Gross Profit (c)	$3,000
Gross Margin (c / a)x 100(3,000 / 10,000) x 100	30%

 

The most common item to impact on gross margin are discounts allowed to customers. Historically discounts have been offered for volume orders or for prompt payments, but the increased availability of knowledge for consumers is seeing discounts offered more often now as a competitive strategy.

Depending on the level of Gross Margin in a business, the effect of offering a discount could be detrimental to the business. Assuming a gross margin of 20% on any product, the effect of offering a 10% discount means that the business is required to sell double the volume of product at a discount to achieve the same level of gross profit to cover the operating expenses of the business.

Mark-up

Mark-up is the gross profit made in relation to the cost of the product.

Example:
Sales (a)	$10,000
Cost of Goods Sold (b)	$7,000
Gross Profit (c)	$3,000
Mark-up (c / b)x 100(3,000 / 7,000) x 100	42.9%

It can be seen from the calculation that these two financial ratios mean quite different things even though they are both related to the profits. Consider the impact to your business of agreeing to terms on something that you have incorrectly interpreted…

Net Margin

Net Margin is the amount of net profit being made expressed as a percentage of revenue. Net Profit is the profit that remains in the business after taking into account the operating costs of the business such as rent, electricity, insurance, wages, tax etc.)

Example:
Sales (a)	$100,000
Cost of Goods Sold (b)	$70,000
Gross Profit (c)	$30,000
Gross Margin (c / a)x 100(30,000 / 100,000) x 100	30%
Operating Expenses
Rent	$5,000
Electricity	$1,000
Telephone	$800
Marketing	$5,000
Wages	$10,000
Insurance	$500
Taxes	$2,300
Net Profit After Tax (d)	$5,400
Net Margin (d / a)x 100(5,400 / 100,000) x 100	5.4%

If the gross margin of the business is under control, the most important aspects of controlling the Net Profit Margin will be ensuring that the costs of the business are under control. Once there is an understanding of the relationship of fixed costs to profits it is possible to calculate the point of break-even, but that’s an entirely different topic that you can read more on.

 

In the next issue we’ll look at some of the balance sheet financial ratios. If you have any questions that you would like answered, please send us a message and we’ll try to incorporate it into the content.