Important Accounting Ratios (Profit Margin, Asset Turnover, Financial Leverage)

This week we have an exciting conversation about accounting ratios! Watch now!

VIDEO SUMMARY

If you work in accounting or corporate finance, you need to know accounting ratios. You need to be able to understand them and speak intelligently about them. They are very useful in running an organization. Let me give you a few examples. If you are an auditor, one of the things you do is look at a company’s ratios. If you are making an investment decision, you compare companies by looking at their ratios. If you are a CEO, one of the ways you evaluate your performance is based on ratios. There are many different ways ratios can help you make better business decisions.

What is a ratio? A ratio is a comparison of two different numbers with a meaningful relationship. There are two parts to this. There is a calculation and then there is the meaning. And you can look at ratios externally or internally. Looking externally, you are comparing different companies. Looking internally, you are analyzing your own company’s performance and seeing how ratios change over time. There are hundreds of different ratios out there. My goal is to give you an introduction into how ratios work, so I am going to talk through three different ratios.

The three ratios we are going to talk about are:

• Profit Margin
• Asset Turnover
• Financial Leverage

Profit Margin is Net Income divided by Sales. This is your measure of profitability, or how much profit you are making off every sale. Let us imagine you are selling shirts. If you sell a shirt for $100, and it cost you $50 to make, your Net Income is $50. Net Income divided by Sales is 50 divided by 100, which equals 50% or $0.50 on the dollar. For every dollar of Sales you generate, $0.50 turns into profit. Typically you are looking at a whole business, so $1 Million in Sales would generate $500,000 in profit. This also tells you that if your sales doubled to $2 Million, all things being equal, your profit would be $1 Million, or 50%.

What does this mean? Profit Margin tells you whether you are a high margin business or a low margin business. That understanding drives your operational decisions. The way low margin businesses make money is they make a little bit of profit off every sale. That little bit of profit is okay as long as you make a lot of sales, because those little amounts can add up to a lot. The opposite is a high margin business where each sale makes a lot of profit, so you do not have to make very many individual sales. One approach is not better than the other, but the understanding of which business you are in will help drive your decisions.

Next is Asset Turnover. Asset Turnover is Sales divided by Assets. Let us go back to the shirt example. Let us imagine you make $1 Million in sales, and your business has assets that are worth $250,000. Your Asset Turnover is 4 to 1, or simply 4. This is sometimes referred to as “Four turns per year.” You are taking your resources and turning them into sales four times each year.

What does this mean? This is basically saying how much you have sold. Sales by itself can be misleading. If you just see $1 Million in sales, that may seem like a lot of money, but it means something very different if you are talking about $1 Million from selling paperclips versus selling cars. By comparing sales against assets provides you a better understanding of how much you have actually sold. This is useful to know in relation to profit margin. If you have a low profit margin, you better have a high asset turnover. If you have a high profit margin, you can afford to have a low asset turnover.

You might be saying, “The best outcome would be high profit margin and high asset turnover.” That is not typically how the real world works. You typically see profit margin and asset turnover move in opposite directions because of the forces of economics. We have talked before about supply and demand. As you drop your sales price, demand increases, which means the quantity you sell increases. But as you drop your sales price, that means your profit margins are decreasing even though your asset turns are increasing.

Now let us talk about Financial Leverage, which is Assets divided by Owner’s Equity. This looks at how a company is being financed. We all know the famous balance sheet equation Assets equals Liabilities plus Owner’s Equity. This equation is looking how your balance sheet is divided between liabilities and equity, or how much debt does your company holds. Is your company a high debt holder or a low debt holder? There are pros and cons to both approaches. So for example, if your company had $250,000 in assets, and $125,000 was from shareholder investment, your Financial Leverage is 2. This means for every $1 invested in the business there are $2 worth of assets. In other words, investors are leveraging their money by doubling their investment based on the creditworthiness of the business. You can also look at it the other way, and say that investors only have a claim to half the assets in a business and creditors have a claim to the other half.

What does this mean? Let me give you a very practical example of how this impacts your operations. You might experience this if you work in a business that goes through a leveraged buyout. This is a pretty common example where one group of investors comes in and buys a company using a lot of debt. Before the sale, the company has low debt and high equity. After the sale, the company is financed differently and has high debt and low equity. In this situation, your financial leverage ratio changes significantly in one day, and you will see that change dramatically impact your operational decisions. Suddenly your operations become focused on making your debt payments. One approach is not necessarily better than the other, these ratios just provide understanding which is very useful.

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Neither Zach De Gregorio or Wolves and Finance Inc. shall be liable for any damages related to information in this video. It is recommended you contact a CPA in your area for business advice.