Part 1 of 3-Part Series
Since the beginning of this year, we’ve focused on a number of ratio’s which are important when managing wealth. These ratio’s take the multitude of numbers and put them into easy-to-understand ratio’s which give a snapshot the state of wealth affairs. Every one of these ratio’s has been a personal wealth ratio because managing personal wealth is what we do and they are what is most applicable to your personal financial life. However, this month we’ve delve into the first business focused ratio and this is because many of our clients are business owners. If you have your own business, it ultimately affects and is a huge part of your personal finance and it can’t be ignored. By bringing this aspect of our many business owner clients into the fold, it follows our unique model of managing your personal wealth in the same way a business would be run.
The ratio which we’re focusing on in known as the profitability ratio and as you can imagine is the most important ratio because at the end of the day, profit is the number which matters. But as we explore the business world of finance, you’ll notice very quickly that it is not so simple as personal finance, and there are many ways to define something like profit. The profitability ratio is actually not a single ratio, but a number of them, with 8 being the most commonly used. The profitability ratio is split into two categories, margin ratios and return ratios.
Margin ratios are used to show a company’s ability to turn sales into profits. But as we mentioned before, there are many ways to look at profit and these are what make up the 5 most common profitability margin ratios. These are made up of gross profit margin, EBITDA (earnings before interest, taxes, depreciation & amortization) margin, operating profit margin, net profit margin and cash flow margin.
Return ratios on the other hand are used to measure a company’s ability to generate return to its shareholders. The three most common profitability return ratios are return on assets, return on invested capital and return on equity. Most of these return and margin ratios are calculated by comparing income to sales, assets and equity.
Part 2 continued next week.