Many business owners think that profit is the most important measure of financial performance, but this isn’t necessarily the case because profit is relative to the amount of money invested in a business. For example, a P100,000 net profit may not really be a good one if the investment is P2 million because the return on investment would be only 5 percent. However, if the investment is only P500,000 and the net profit is P100,000, the return on investment would be a fantastic 20 percent!
Thus, you need to design a financial strategy that can help you achieve the highest possible return on your investment, and you can do this by developing a strategic profit model using the following three key indicators: profit margin, productivity, and financial leverage.
Computations and how these numbers can help you
Profit margin is derived from dividing your net profit by your net sales. For example, a total net profit of P50,000 divided by net sales of P150,000 yields a net profit margin of 33 percent (P50,000/P150,000 = 0.33 x 100 percent = 33 percent). This percent profit margin indicates that for every P100 of your sales, you earn a P33 profit net of all expenses.
Profit margins, of course, tend to fall when cost of sales or operating expenses increase. On the other hand, when you increase your selling price or increase your volume sales, profit margins go up. You therefore need to manage your margin constantly to achieve your profit targets. For example, if your power cost shoots up because of an increase in electricity rates, you need to bring down your costs in other items or consider raising your selling price so you can keep your margin unchanged.
Although margin management is a crucial component of the overall financial strategy of your business, it doesn’t by itself provide a complete picture of your financial performance. You also need to have an indicator of your company’s productivity. This can be calculated by dividing your net sales with your total assets.
For example, if your total net sales is P150,000 and you have total assets of P1 million, your productivity ratio would be 15 percent (P150,000/P1 million = 0.15 x 100 percent = 15 percent). This ratio means that the business generates 15 centavos-worth of sales for every peso invested in assets.
The higher the productivity ratio, the better for you because it indicates how productively your management has used your company’s resources to generate sales. However, it is possible for you to have a high profit margin but a low productivity ratio. This happens when you have excess cash in the bank, or when you have large uncollected accounts receivables or when you have invested too much in largely idle real estate.
After looking at the asset management side of your business, you need to check the liability side, which can be measured by your financial leverage. Leverage is computed as total assets divided by net equity. Net equity, sometimes called net worth, is the amount of money that you have actually invested in the business.