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Business financial health

It happens that a company looks successful, healthy and rich: every month it opens a new branch, hires its second thousand employees and does not leave the front page of Forbes. But then – once, and bankruptcy. This happens when the owner looks only at the scale of the company or turnover, and these are not indicators that really reflect the financial health of the business. About those – in the article.

0. Profitability
Before we get into the metrics, let’s look at the types of profitability. There are six of them:

profitability by margin;

by gross profit;

operating profit;

by net profit;

return on assets;

and own capital.

Each of the profitability signals a problem at different levels. The first four are associated with different types of profit and schematically look like this:

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The last two returns are related to assets and equity. Assets are everything a company has, while equity is assets minus liabilities, such as loan payments:

Click to enlarge

Each profitability is a tell-tale indicator of financial health, and these lights can be used to track at what stage the business began to get sick.

Let’s start with profit margin.

1. Profitability by margin. Checking the reasonableness of variable costs
Profitability by margin shows what percentage of the revenue the company keeps for itself, and what it spends on the production of goods or the provision of services.

Igor is a hairdresser, he charges 1,500 rubles for hair coloring. From this amount, he buys paint, mask, balm, brush and gloves. And he has 500 rubles left. Its profitability in terms of margin is 33% – this is how much money he has left after buying consumables.

Victor is a builder. He sells apartments for 6 million rubles, and spends 3.5 million on construction and all this, leaving him 2.5 million rubles. Profitability by margin – 41.6%.

Profitability by margin is calculated according to the following formula:

(marginal profit / revenue) * 100%.

Marginal profit is revenue minus variable costs, that is, those costs that arise when a company receives an order. For example, an order for a dress comes to the atelier – the atelier buys fabric and beads. There is no order for a dress – there are no costs for fabric and beads either, which means that this expense is variable.

Marginal profit is calculated by themselves or taken from the OPiU – profit and loss statement, if there is such a line. Revenue and variable costs are also taken from OPiU.

We calculate profitability by margin
We go to OPiU and first we calculate the marginal profit for each month. To do this, subtract variable costs from revenue, for example:

in May: 951,050 – 267,705 = 683,345 ₽

June: 900,000 – 200,500 = 699,500 ₽

July: 982,300 – 275,600 = 706,700 ₽

August: 1 100 00 – 456 980 = 643 020 ₽

This is what we calculated marginal profit. Now we substitute it into the formula for calculating the profitability by margin: divide the marginal profit by revenue and multiply by one hundred. It turns out:

in May: 71.8%

June: 77.7% ⬆️

July: 71.9% ⬇️

August: 58.4% ⬇️

And we see that the marginal profit margin is falling: in May it was 71.8%, in August – 58.4%. So, you need to look for a problem in variable costs: perhaps suppliers have increased the price of raw materials or the company has begun to use more expensive materials.

Profitability by margin is looked at in dynamics: if it grows from month to month, then everything is fine. If it falls, then you need to reconsider variable costs.

Profitability by margin: growing – good, falling – checking variable costs

2. Profitability on gross profit. We check the effectiveness of business lines
Gross profit margin shows how effectively different lines of business are performing. For example, if a coffee shop has multiple outlets, the gross profit margin will show which one is generating the most profit and which one needs to close.

Gross profit margin is calculated as follows:

(Destination Gross Profit / Destination Revenue) * 100%

Gross profit is the revenue of a particular area minus the variable and overhead costs of the same area. The expenses are calculated by themselves or taken from the OPiU, they also look at the revenue.

For example, an IT company has four areas: web development, mobile, devOps, and design. To understand which direction is more profitable to engage in, the company calculates the gross profit margin separately for sites and applications.

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The example shows that web development generates the most revenue, but the company earns the least from it. It is more profitable to engage not in web and mobile, but in design and devOps: although they bring less revenue, they require less costs.

If the gross margin is falling or very low compared to other destinations, the cause must be looked for, such as checking variable or production costs. Perhaps something needs to be closed.


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