Is your business in good financial health? Check it with help of ratios! Part 3

We have already talked about liquidity and financial position, which are vital for the survival and stable structure of your business. Profitability is an element that is responsible for 'feeding' your business so to speak. It's not only important to know what is your revenue figure, your operating and net profit, but it's equally as important to understand these figures in a context.

Just knowing that your business makes enough money to bring you a satisfactory salary is not enough. Let's put it into perspective. Let's say, your business is bringing you £45,000 a year before tax. That's not too bad, right? The question is, how much did you have to invest first to gain that money. Does £45,000 profit a year mean the same for a business with a capital of £1000, £30,000 or £250,000? It does make a big difference, right?

You have to take into consideration, that the same ratios, using the same calculations will have a different meaning for self-employed, and yet different for a limited company. This is because owners of these two different forms of business take the money out of their business in a different way. Owners of a limited company might (but they don't have to) have a salary and this will be deducted from the profit from operations, however for self-employed it isn't, and so all profit from operations is actually treated as the owner's personal income. For the same reason, I'm not going to talk here about the return on shareholder's funds. In this ratio, we take into consideration profit after tax. We shouldn't compare profit after tax of limited company and self-employed, as tax rules and amounts paid will be meaningfully different, and usually profit for sole traders' business is taxed only as a part of the owners' personal income, so in other words, it's not the business that's taxed, but the owner directly.

To illustrate this, here is an example:

Let's compare two companies: a sole trader's business and a limited company. They both have the same gross profit of £60,000. Both are owned by one person only. Both owners take £40,000 of the profit as their personal income and re-invest the rest in the business. In the limited company, the owner is also the director and have decided to take his money out as a salary.

Self-employed Limited Company

Revenue 85,000 85,000

Cost of goods sold 25,000 25,000

Gross profit 60,000 60,000

Administrative costs 5,000 5,000

Directors salary Not applicable 40,000

Operating profit 55,000 15,000

Finance cost 2,000 2,000

Net profit 53,000 13,000

Tax Not applicable 2,400

Net profit after tax Not applicable 1,600

The net profit of £53,000 from the sole traders' business is part of his personal income and will be taxed as such.

As you can see net profit in both companies is wildly different, although both companies have got the same gross profits and costs other than salaries. This is why you should not compare the ratios of limited companies and sole traders.

Gross profit percentage & operating profit percentage

Just because the business makes sales doesn't mean it is profitable, because it also incurs cost. When the cost is higher than revenue (sales) then the business is not profitable. However, assuming, that the business is making money, the business owner should want to know, how efficient is his business. In other words, how much of the money that the business gets from its customers stay in the business. It is the gross profit percentage and operating profit percentage that tells us how well does the business do in terms of making money out of its sales. By calculating these ratios we compare the revenue and profit after deducting different costs. Gross profit percentage shows us, what percentage of revenue stays in the company after we cover the cost of making the product that we sell. The operating profit percentage will tell us what percentage of the sales business keeps after all costs relating to its operations, but excluding finance cost, tax, and other non-operation related costs.

Gross profit percentage= Gross profit/revenue %

Operating profit percentage = Operating profit/revenue %

For our example, these ratios will be as follow:

Self-employed Limited company

Gross profit ratio 70% 70%

Operating profit ratio 64% 17%

Return on capital employed

I already spoke about the capital employed in my previous post. It is calculated as total equity plus non-current liabilities. It shows us the full amount of money that was used to start and extend the company's operations. By calculating this ratio we want to find out how well is this money working.

Return on capital employed = profit from operations/capital employed %

Let's assume, that for our example, both the self-employed and the limited company have invested £100,000 and that they both have borrowed £20,000 from a bank. That totals £120,000 capital employed in both companies.

The return on capital employed ratio will be then as follows:

Self-employed 45%

Limited company 12.5%

As you can see, here also the percentage will be different because of how the owner's salary is treated in the calculation of the profit. It is important to remember this difference when comparing ratios.

Analysing this ratio you have to remember that it tells you about the profitability of the company and not so much about what it brings to you personally. This is especially true for a limited company. As mentioned before if you are the only owner and the director of the company your salary will reduce the operating profit. The ratio also doesn't take into account any dividends paid for you. Its main purpose is to helps you analyse your business as an investment opportunity.

When analysing a limited company's return on capital employed you can simply compare it to other investments available to see if your company is a good investment for you.

If you want to be able to compare your self-employed type business in the same way you'd have to first agree on the amount that you assume would be your salary, that you would be paid for work that you do for your business if it was a limited company. You could then deduct this amount from the operating profit. After you've done that you can then calculate the return on capital employed, and it should give you a lower ratio and one more similar to those of limited companies. This is however still not very accurate and can only give you a rough idea as to how good of an investment your business is comparing to other investing opportunities. For a self-employed business, the ratio analysis gives you information that is vital to you and not so much to others. That means you might have a bit more flexibility with ratios and adjust them for your needs to make up your own key indicators. It is perfectly fine as long as you stick to your variations of ratio and use them consistently.

I hope I have helped you understand how ratios work, and that now you feel equipped to start using the ratio analysis to keep your business' health in check.