To help your business improve its productivity, effectiveness and keep costs low, you will need to regularly measure its actual performance against its estimated/budgeted performance. This is achieved by tracking relevant business metrics, also known as key performance indicators (KPIs). In the forthcoming weeks, we will be discussing measuring business performance in terms of profitability, employees and customers. This week, we will start with measuring profitability.
What is profitability?
To understand profitability, we need to know the definition of profit. Profit can be defined as the excess revenue generated from business activities after expenses have been paid off for a particular period while profitability simply refers to a business’s ability to make a profit. Profit can be considered an absolute value as it may not be compared to other values. Unlike profit, profitability is a relative value and it represents the bottom line of a business at a particular point in time when compared to other variables like competitors.
In order to measure profitability, the financial performance of the business needs to be ascertained and this is possible when proper financial records of the business transactions are kept.
Factors to consider when reviewing financial performance of the business include cashflow, working capital, cost base and growth. A constant review of these will ensure that the business is not spending more than it earns and also measures the effectiveness of set metrics.
There are different types of profit metrics used to measure a business performance in terms of profitability. Here are some common metrics:
Gross profit margin: this shows the profit made after deducting direct cost of sales.
Operating margin: this is the amount left after all overheads and interest have been deducted.
Net profit margin: this shows the relative efficiency of the business after taking into account the revenues and expenses.
Return on capital employed: this shows the overall profitability of the business. It is usually calculated in percentages.
Aside from the above listed metrics, there are others known as accounting ratios for measuring financial performance, such as liquidity ratio, long-term solvency and stability ratio, and investors ratios.
Liquidity ratio: This measures the ability of an organisation to fulfil its short-term financial obligation.
Long term solvency and stability ratio: This measures the ability of an organisation to fulfil its long-term financial obligation.
Investors ratio: This metric is used by investors to assess the company’s ability to maintain profitability and generate return on investment.
How can a business measure profitability?
Define the objectives: primarily, every business is in existence to make a profit. However, it is important to set at least two to three objectives to serve as guidelines for measuring profitability rate.
Determine methods for achieving the set objectives - next, a business should draw a clear map showing the different methods it could adopt to achieve the set objectives and select the most effective to focus on.
Identify key drivers involved in achieving set objectives - Cost, sales and profits are some of the financial drivers that affect the financial performance of a business while customers and employees are some of the non-financial drivers that affect the financial performance of the business. In the coming weeks, we will discuss some non-financial drivers.
Monitor and evaluate the process - once a working system has been put in place to measure financial performance, it is crucial that this system is reviewed at regular intervals to ensure effectiveness.
In summary, businesses must understand how to measure profitability using the right metrics to ensure it is on track with set objectives.
If you have any questions regarding how to measure your profitability for your business, email us at enquries@ovacgroup.com.