How can you measure a business’s profitability, efficiency, and investment potential? Why should you analyze your financial statements like investors?
Karen Berman and Joe Knight discuss several key financial ratios that managers, investors, and analysts use to evaluate a company’s performance and financial health. Berman and Knight identify several important financial performance measures that indicate a company’s profitability, efficiency, and overall financial strength.
Here’s how to use performance metrics to measure a company’s overall health.
Performance Measures for Profitability
To determine a company’s profitability, Berman and Knight offer three financial performance measures:
- Gross profit margin: Divide the gross profit number on the income statement by the total sales. This tells you how profitable your products and services are in and of themselves.
- Operating profit margin: First, subtract your operating costs from your gross profit, then divide by total sales. This percentage lets you gauge the profitability of your core business operations.
- Net profit margin: Divide the income statement’s net profit amount by your total sales—this lets you assess your overall profitability after all expenses.
Berman and Knight recommend that you track these ratios over time to spot trends in your company’s profitability. These margins show you how effectively your business generates profits at different stages of the money-making process. For instance, if your gross profit is high but your operating profit is low, then you may be paying too much overhead in day-to-day business operations. With these numbers, you can also compare your performance to business competitors and industry benchmarks.
Performance Measures for Efficiency
To measure a business’s efficiency using financial statements, Berman and Knight say to turn to your balance sheet, from which you can assess how well your business is using its resources. For instance, you can measure how quickly you sell your inventory by dividing the average value of the inventory you keep in stock by the cost of goods sold on a daily basis. You can compute how fast customers pay their bills by dividing the amount of money your customers owe by your average daily sales, letting you know how efficient you are at collecting payment for the goods you provide. Finally, you can calculate the turnover rate of all your company’s assets by dividing your total revenue by the value of everything your company owns.
(Shortform note: Another way to look at resource use in addition to Berman and Knight’s numbers-based approach is to view it in terms of customer satisfaction. In The Personal MBA, Josh Kaufman argues that the more efficient your operations, the better position you’ll be in to provide high-quality products and services that outdo your competitors. Therefore, on top of your balance sheet analysis, Kaufman says to come up with a list of both minor and major improvements you can make and prioritize those that will make the biggest difference to your efficiency and profits, in terms of their impact and consequences for your business.)
The trick lies in recognizing whether your efficiency numbers are good or bad. Berman and Knight explain that this is largely subjective and changes from industry to industry. Nevertheless, you should track your efficiency numbers over time and compare them to industry standards so you can identify areas for improvement in your business operations. You must also recognize that your efficiency numbers rely heavily on your company’s balance sheet and will reflect any assumptions that you or your accountants make in preparing that document.
(Shortform note: Depending on your industry, there are a plethora of standards to grade yourself by that Berman and Knight don’t specifically go into, many of which are set by the International Organization for Standardization (ISO). To determine which efficiency standards are appropriate for your company, you can start with quality management standards like ISO 9001, which can improve your processes and customer satisfaction. Environmental standards such as ISO 14001 demonstrate your commitment to sustainability, whereas health and safety management standards like ISO 45001 maximize your workplace’s safety. By assessing your company’s needs in these and other areas, you can prioritize which standards are most vital to improving your business processes and ultimately increasing your profitability.)
Performance Measures for Investment Potential
While managers view their businesses from a different perspective than Wall Street investors, Berman and Knight say that it’s important to analyze your financial statements the same way that potential investors will. This is especially crucial if your business wants to finance itself by bringing in shareholders rather than by taking on debt. To make your business more attractive to investors, you need to know what they’re looking for and, if needed, find ways to improve your performance in those areas.
(Shortform note: Especially for startups, attracting investors will almost surely be necessary at some point—a process depicted on the reality TV show Shark Tank. Investors on the show use several methods to value entrepreneurs’ companies. They start by examining revenue, manufacturing expenses, and other overheads to calculate prospective companies’ profit margins. To put these numbers in context, they often compare the startup’s metrics to those of their direct competitors. Finally, the investors also weigh intangible factors like brand recognition. If you, as an owner, analyze these factors first as Berman and Knight recommend, you’ll have done much of your potential investors’ work for them.)
First off, investors expect to see a business’s revenue expand over time. The authors note that sustainable growth rates vary by industry and company size, but consistent growth is key. Another measure investors expect to increase is the amount of earnings per share (EPS), which is the net income on the income statement divided by the company’s total number of shares. This is a metric that investors want to see going up even during economic downturns. Also of value to investors are a company’s ability to generate cash beyond its operating needs and how efficiently a company uses its capital to generate returns for its owners. The latter is reflected in the return on investment (ROI), which we’ll cover in more detail next.
(Shortform note: The revenue and earnings growth that Berman and Knight show how to calculate are certainly important to investors, but not every kind of growth is good for business. Sometimes, a runaway success can actually be dangerous, especially for startups. Rapid growth leads to financial strain by increasing a business’s operating costs and the size of the workforce it needs, both of which can trigger a cash flow crisis and skew the numbers on your balance sheet and cash flow statement. Additionally, unsustainable growth can cause employee burnout and lower levels of customer satisfaction, undermining your company’s reputation.)
