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Financial health of a business: 9 indicators for a check-up

It happens that a company looks successful, healthy and rich: every month it opens a new branch, hires two thousand employees and does not leave the front page of Forbes. But then – again, and bankruptcy. This happens when the owner looks only at the size of the company or turnover, and these are not the 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 ROIs. There are six of them:

return on margin;

by gross profit;

operating profit;

by net profit;

return on assets;

and equity capital.

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

Click to enlarge

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

Click to enlarge

Each ROI is a financial health diagnostic light bulb, and these light bulbs can be used to track at what stage the business started to get sick.

Let’s start with the ROI.

1. Profitability by margin. Checking the reasonableness of variable costs
The profit 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 dyeing his hair. From this amount, he buys paint, mask, balm, brush and gloves. And he has 500 rubles left. His profitability in terms of margin – 33% – is how much money he has after buying consumables.

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

The profit margin is calculated using the following formula:

(profit margin / revenue) * 100%.

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

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

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

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

in May: 71.8%

June: 77.7% ⬆️

July: 71.9% ⬇️

August: 58.4% ⬇️

And we see that the profitability of the margin is falling: in May it was 71.8%, in August – 58.4%. This means that the problem must be looked for in variable costs: it is possible that suppliers have increased prices for raw materials or the company has begun to use more expensive materials.

The 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 revise the variable costs.

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

2. Gross profit margin. We check the effectiveness of business areas
Gross margin shows how effectively different lines of business are performing. For example, if a store has more than one outlet, the gross margin will show which one is generating the most profit and which is the time to close.

The gross profit margin is calculated as follows:

(gross profit of the direction / revenue of the direction) * 100%

Gross profit is the revenue of a particular line minus the variable and general production costs of the same line. Expenses are counted themselves or taken from the OPiU, they also look at the proceeds there.
For example, an IT company has four areas: web development, mobile, devOps and design. To understand which direction is more profitable to pursue, the company calculates the gross profit margin separately for sites and applications.

Click to enlarge

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

If your gross margin falls or is very low compared to other areas, you need to look for a reason, such as checking variable or operating costs. Perhaps something needs to be closed.

Gross profit margin: growing – good, falling – check what’s wrong with the direction, and isn’t it time to close it

3. Cost-effective

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