Activity ratios measure how effectively resources are being used. The question is whether you generate a good return on business activities. And no, this isn't return on investment. Let's look at the average collection period ratio. Paul's annual sales are $1,460,000, or $4,000 per day. His receivables are listed on his balance sheet as $160,000. His contracts require payment within 15 days.
Paul's customers are taking 2-3 times longer to pay than stipulated in his contracts; he needs to accelerate collections. Alternatively, he could change how he does business -- maybe collect deposits or retainers to reduce his average collection period. There is too large a gap between activity completion and payment.
Profitability ratios measure return on sales and investments. This is often the first ratio that investors consider. Are you making the profits and margin that you promised? Paul sells $1,460,000 per year. His net profit after taxes is $80,000.
Paul is underperforming his target profit margin by more than 5%. This could be due to one-time startup costs, pricing, or something else entirely. The missed target certainly requires a closer look.
When confronted by disappointing results, the first step is to go beyond the simplistic financial ratios to understand what is causing the problem. To improve profitability quickly, most businesses will try several common tactics:
- Think about other ways to do things
- Eliminate some things
- Do less of some things
- Combine some things
- Do things in a different way
A word of caution
Though a ratio can illuminate one area of your business, ratios are taken at a single point in time. What matters most is the trend of your ratios. Are they moving in the right direction over time? How much does seasonality matter in your business? What would be more informative -- a month-over-month look or a year-over-year look? It is important to compare data from similar sources and draw valid conclusions based on real data.
Most ratios involve only a few numbers. Many use division of simple numbers. Graphics can help you understand the information. Engineers, especially those with experience in process control charts, are well equipped to present data in useful ways. Statistical process control (SPC) charts are a good way to communicate, but many professionals without SPC training will be more comfortable with pie charts, bar charts, trend lines, and other representations. By observing trends over time, you can use them to make better, more informed business decisions.
Most businesses are about making maximum profits for shareholders. Read your company's annual statement. This one document will allow you, as a practicing engineer, to know your business and can help you glean some very useful insights. The more you know about financial ratios and which ones are the most important for your company to report, the better you can anticipate management decisions that may affect you and your colleagues.