Maximizing profits

BUSINESS BITS
Henry Ong

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 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.

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 the 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 now 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.

Assume, for instance, that you have total assets of P1 million and equity of P500,000. To compute for the leverage ratio, you need to divide P1 million by P500,000, which yields a leverage ratio of 2.0 (P1,000,00/P500,000 = 2.0).

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.

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. You may reach him at hong@businesssense.com.ph or www.businesssense.com.ph.]