Some call it the art of business. Others refer to it as business science. Most are confused by it. Not that anybody ever admits to being confused.
It is something that exists in any business, whether we like it or not. If a business owner uses the information, it can be a very handy tool to gain profitability and therefore, greater value. What am I referring to? Ratios inherent in almost everything you do as a business owner. The most obvious is the gross profit ratio, usually called the GP%. It is simply the gross profit of the business divided by the sales. That is a simple concept which I have covered before.
On a fairly regular basis, I am asked what the ROE on someone’s business should be, or the ROA (or any of the GP, current ratio, quick ratio, interest cover, and a whole lot of others). Here is the problem: At an academic level, there may be a “correct” theoretical level. But in a small country (with a smaller economy than some European and USA cities!) it is almost impossible to tell the owner of a pipe extrusion factory what the optimum level of any of these ratios should be, in comparison to similar businesses. The size of the sample is simply too small to make any meaningful comparisons.
It is also a smoke screen to bulldust, and a it is a con to claim to be able to compare the ratios to similar businesses from a database of millions from other countries where basics such as interest rates, infrastructures, wage demands, political imperatives and socio economic expectations are so different.
Here is an example from Guide to Analysing Companies by Bob Vause – an Economist publication:
These are the typical pre-tax profit to sales ratios for various industries (columns) in different countries (rows). Think of the numbers as percentage of sales turnover.
So how does that help us?
It’s a rhetorical question, because it couldn’t possibly help us. On the other hand, look at this:
This is the sales curve of one of our clients. It is rising nicely – well ahead of inflation, and should be the source of some pride. The problem was that over several years his bottom line profits were declining in Rand terms. This, despite the fact that he kept a solid lid on fixed expenses.
Some very basic ratio analysis revealed this:
Suddenly his problem is highlighted in very graphic detail. He had been chasing turnover at the cost of his gross profit ratio. With the higher turnover comes higher risk in holding more inventory, bigger debtors’ book, higher banking fees, more labour etc. Ultimately, his net profit before tax (NPBT) suffers. And that is what really counts.
As it happened, he was being bullied by his biggest customer into taking smaller and smaller margin on bigger and bigger orders, even though his only competition was on the other side of the country.
Year after year he was presented with his financial statements and told that his ratios were within industry norms. In isolation, they may well have conformed to something in a text book or an industry web site, but in reality, the norm just did not work for our client.
Happily, he is working towards lifting his GP%. His higher prices are lifting his sales turnover, and the quantity of product continues to rise, making for an even happier client. His experience in keeping overhead under control, continues to pay off. The bottom line is that over the next few years, the value of his business is likely to multiply by 5 or 6 times, based on our projections.
The point of this illustration is to show you that when someone tells you that he has the metrics of 100,000 businesses, and can guide you accordingly, you should take that information with a pinch of salt. The only reasonable comparison, in my opinion is to compare such things internally within a business to the same calculations in previous periods, and then to work towards regular, measurable improvements.
Part of our valuation process involves looking, not so much at what the ratio between two numbers is, but more importantly, and infinitely more useful, the trend of that ratio, and others which may relate to it. You can do this at home, and it will make a lot of sense, as long as your financial statements are prepared on the same basis every year. Calculations can even be done on a monthly basis, and compared monthly, as long as you keep in mind that annual results will be different from monthly results, given the different reporting standards.