This ratio means that for every peso you invested as equity, you have two pesos worth of assets. Another way of saying this is that you borrowed one peso for every peso of investment you made. The higher the leverage ratio, the more money you borrowed to finance your assets. An increase in leverage ratio is good in the sense that you are using more of other people’s money than your own to increase your sales and profit margin. However, it also increases your risk of going bankrupt if you are not able to pay your debt on time.
When you multiply the three indicators with one another, you get what is known as the return on investment: profit margin x productivity x leverage = return on investment.
If, say, you have a profit margin of 33 percent, a productivity ratio of 15 percent, and a leverage ratio of 2.0, you get a return on investment of 9.9 percent (0.33 x 0.15 x 2.0 = 0.099 x 100 percent = 9.9 percent).
You can see that an increase in any of the three indicators will increase your return on investment. On the other hand, if one indicator falls, say your profit margin goes down by 1 percent, you need to manage any of the two other indicators to increase by 1 percent to offset that decrease in profit margin and keep you on track in attaining your desired return on investment.
Why you need to develop a profit strategy
Depending on industry structure, there are businesses that focus more on productivity rather than on profit margins, while others consider leverage as more relevant than productivity, but they all seek to achieve the same thing—an acceptable return on investment.
For example, if you are a retailer, say a supermarket or a convenient store, your profit margin would be rather small—perhaps only 3 percent. To generate your target profit level, your focus would then be more on increasing the turnover of your investment.
Developing your own strategic profit model and making it your financial strategy will greatly help you monitor and evaluate current performance and identify potential problem areas. With the statistics that you already have, you can do historical comparisons to see whether your performance has improved or deteriorated over time.
You can also use the profit model to set financial targets by comparing your actual ratios with industry standards. By such benchmarking, you can discipline yourself to performing either at par or better than industry average.
Lastly, you can also anticipate the financial impact of any changes that you make in your marketing or operating strategies. For instance, by using Excel spreadsheets to simulate variations in any of the three indicators, you can easily do a “What-if analysis” to help you make better decisions.
You need to remember two more things when constructing your profit model:
- One is that you must have accurate financial statements— particularly your balance sheet and income statement—because the data you need for your computations will come from these documents.
- The other is that when you implement your strategy, you must involve not only your top management but also every employee in your company. This way, you can have the job goals of each of them translated into some specific measure of economic performance.
Henry Ong, CMA, RFP, is president and COO of Business Sense Inc., a financial advisory and consulting firm that helps small and medium businesses. Business Sense is affiliated with INPACT International Network of Certified Public Accountants.