Published: Feb 02, 2022
Measuring the profitability and growth potential of a business can be done through the use of a number of various performance ratio which I will go into detail. However, the first effective step for any business owner to get a better grasp on a company’s earning power is by putting together a business plan that reflects your objectives. Having a business plan that outlines these objectives provides management with a purpose or a starting point, a line in the sand that gives you the opportunity to highlight where you want to get to, key milestones and whose help or input you will require along the way. You should regularly review your plan and revise if required. You may look to cover aspects such as your business’s product or service, your market and/or routes to market, suppliers, competitors (and how your business compares) and last but no means least your financials.
If your business is looking at a growth scenario, then it is important to demonstrate that the projected growth is realistic, scalable and fundable. All businesses looking for funding need to have a robust and detailed plan in place prior to approaching potential funders or investors otherwise you run the risk of not allowing investors or fund managers to recognise the potential value of your business.
As I touched on earlier measuring profitability and growth is done through utilising profitability ratios and break-even analysis. Profitability calculations help you to analyse realistic price levels, profit margin and sales revenue. Profitability ratios also refer to the financial metrics used to assess ability to generate earnings against sales and costs. Generally, the higher the profitability ratio, the better the business is making use of its resources to generate profits, cash and create value. These ratios are most useful when comparing to either your business’ historic financial data, your industry average or competitors. Margin ratios are the most commonly used profitability ratios and provide an insight into the ability of your business to convert sales into a profit. Gross Profit Margin Ratio is very simple to assess: take your gross profit as a percentage of net sales.
The cost of goods sold is the price your business pays for the products/services it sells which will include the cost of materials and staff costs incurred directly to produce your goods/service. This ratio excludes indirect costs and expenses such as marketing and overheads. Gross Margin Ratio is an important indicator of your business’ financial health and should be stable and not deteriorate from one period to the next unless this can be justified by one-offs such as a change in the product mix. An adequate and strengthening gross margin indicates that your business has growth potential as well as the capacity to pay its operating expenses.
Net Profit Margin Ratio indicates the amount of net profit your business generates from its total revenue and is net profit as a percentage of net sales. It indicates how revenue/sales gets converted into bottom line profit so includes cost of goods sold, sales costs, general and admin costs, depreciation, interest, tax and other expenses. The Net Profit Margin Ratio is therefore a vital indicator of the health of your business as it demonstrates whether your business is generating sufficient profit from its sales and whether costs are under control.
Knowing your breakeven point provides the minimum sales target for your business. It therefore helps you determine the relationship between revenue, product costs and sales volume.
If your business is generating profits then your breakeven point lets you know the amount of buffer you have if sales decline and on the flip side if your business is making losses, you can determine how far you are from making profits.
The third effective way to measure your business’s profitability and growth is through a customer value calculation or assessing your customer base. The process of acquiring new customers and retaining existing ones requires a lot of work in terms of understanding, as well as implementation of knowledge gained and current best practices. One solution is the Customer Lifetime Value metric (CLV).
Customer Lifetime Value is your tool for assessing exactly how much revenue any given customer is likely to generate across the time frame they interact with your business. Customers who spend the most over the longest period of time will have the largest lifetime values. To calculate CLV you need to calculate the average purchase value and then multiply that number by the average number of purchases to determine customer value. Then, once you calculate the average customer lifespan, you can multiply that by customer value to determine Customer Lifetime Value.
CLV is very important as understanding it leads to greater customer satisfaction and hopefully retention i.e. how long are your customers likely to stay loyal to your brand. The higher the CLV number, the greater your profits will be. Customer acquisition costs you money as does retention. Rather than just racing around to just keep your head above water, you’ll be able to understand which customers you should be focusing on and more importantly, why you should be focusing on them. CLV is a clear look at the benefit of acquiring and keeping any given customer.
Finally, you need to become fully aware of the market you operate in. Establishing your market share is important to judge the effectiveness of any possible revenue generating effort such as marketing campaigns or customer relationship management programs. Market share shows you how you are doing compared to your competition.
Internal focus may give you satisfaction with your business’ results but that could be misleading if your performance is below par relative to the competition and there is a risk that in time your results decline and you are soon are overtaken by them. It can be useful to undertake a SWOT analysis on both your business and your competitors as this will help tease out your unique selling point (USP) and what sets your business apart from everyone else.
There are also other helpful sources of publicly available information which should be readily to hand when researching your competitors. These include their Annual Accounts which are filed at Companies House (unless a sole trader or partnership) and will provide insights into the financial performance of a business alongside a detailed directors report covering events of the last year and sometimes a look forward. If you are benchmarking against a Public Limited Company or PLC then it’s worth registering on their website for the investor alert service to receive all press releases, financial results and other key shareholder messages.
By way of summary, knowing who your competitors are, and what they are offering, can help you to make your products, services and marketing stand out. You can use this knowledge to create marketing strategies that take advantage of your competitors' weaknesses and improve your own business performance which in turn will increase profitability.
As you can see from the above, there is not one single strategy which is key to the success of your business but by being aware of the importance of profitability, measuring it and constantly tracking your performance, you stand a much better chance of greater profits, growth and success!