Santosh Kenkre explains two important ratios that a business owner should focus on for measuring operating efficiency
Businesses, as well as professions run for years or ages. They can be run well or be run as a routine activity. Two business communities are well known in India for being hardcore businessmen (for obvious reasons I cannot name them here). If I were to single out one reason for their success, I’d say they are ‘very serious’ about their business. They are serious about every rupee which comes in or goes out and constantly see how they can improve ‘sales’, ‘profit’ and control costs.
Is this not similar to what MNCs do? May be MNCs do it in a sophisticated and scientific manner.
This brings us to ‘performance’ of a business. Managements, shareholders (owners) and employees’ are rewarded based on ‘performance’ of the business. Further, bankers and suppliers may not prefer to do business with a badly performing business. Thus performance assumes paramount significance. It is simply a case of ‘Perform or Perish’.
In my humble view, every businessman/professional should evaluate his business at least once in a year (ideally on quarterly basis). For this, there are a multiple ratios which one can use. Even the Ministry of Corporate Affairs now expects companies to disclose 11(eleven) different ratios in the annual accounts and further, explain variation of more than 25% variation over the previous year!
I’m mindful that majority of the readers of this article are business owners. Hence I will delve upon ONLY TWO IMPORTANT RATIOS for measuring operating efficiency. One ratio is for traders (including distributors/super markets) and the other for manufacturers.
For other businesses, similar ratios can be easily devised by improvisation (see later in this article). I’ve tried to keep the ratios as simple as possible for the purpose of easy understanding by business leaders.
- PROFIT TO SALES RATIO:
(For traders, distributors/supermarkets, etc.)
Rs.
- Sales (net of GST) 200
- Add: Closing stock 31st march 2022 20
- Less: Purchases (net of GST/freight, etc.) 160
- Less: Opening stock 1st April 2021 18
- = Gross Profit 42
- Ratio of Gross Profit to sales (5÷1×100) = Rs.42÷Rs.200×100 = 21%
The above ratio reveals how much gross profit the business has made, which is basically sales price (-) purchase price. Naturally, this ratio has to be compared from year to year. By using this ratio, you can try to increase your sales price (if market permits) and/or bargain with your supplier to reduce his price and/or reduce logistics cost/structure.
Obviously this ratio will differ for different goods or even from place to place. Only when a businessman can protect his gross profit, he will be able to absorb his overheads and make satisfactory profit.
- RATIO OF RAW MATERIALS CONSUMPTION TO PRODUCTION
(For manufacturers and similar businesses using materials and machines)
| (Rs.) | |
| 1. Opening Stock of Raw Materials (R. M.) on 1st April 2021 | |
| 2. Add: Purchases of R. M.(Note 1) | |
| 3. Less: Closing stock of R.M. on 31st March 2022 | |
| 4. Subtotal of 1 to 3 = R.M. consumed |
| 5. Sales (net of sales returns, GST) | |
| 6. Add / deduct: Increase OR decrease in stock of Finished Goods / WIP (Note 2) | |
| 7. Subtotal of (5 + 6) = Production figure (simplified) |
| 8. Ratio of R.M. consumed to production: 4÷7×100 |
Notes to above: 1. Purchases of R. M.: (Net of: returns/ Sales of R. M. and Sales of scrap of R. M., etc.) (Net of GST if recoverable)
2. Year end stock of Finished goods and WIP (-) stock of finished goods & WIP at the beginning of the year.
I’ve tried to keep the above ratio, as simple as possible.
Although the above ratio mentions ‘raw materials’ (which is normally 40% to 60% of the total cost), consumption of even other crucial materials eg. Consumables, spares and components, maintenance items, lubricants, etc. can also be thus evaluated. This ratio has to be compared from year to year.
This ratio will guide the businessman to increase his sales price (if market permits) AND/OR to bargain with his suppliers for price reduction and/or to change the logistic costs/structure.
It will be clear that this ratio deals chiefly with manufacturing efficiencies.
OTHER INDUSTRIES: Can improvise their own “top 3” ratios for performance evaluation eg.
- Banks/credit societies/Financial Institutions/NBFCs etc.:
Net Interest Margin and Net Interest Income
- Hospitality Industry: Net room rate realised; season-wise occupancy; salaries as a percentage of sales, F & B cost as a percentage of F & B sales, Housekeeping/repairs & maintenance as a percentage of sales
- Startups/software: Salaries to sales; R & D expenses to sales; cost of funds to sales,
- Builders:
Cost of construction per m2: Compare this project-wise and year-wise.
Net sales price realised per m2: compare this project-wise and year-wise.
- Professionals: Debtors outstanding amount and age thereof.
NOTE: Don’t get cluttered (hence confused) with too many ratios. You may very well monitor maximum 3 to 5 ratios per month.
MUST: Along with above evaluation, the businessman should also compare his costs, products, services with that of his competitors. Thereafter he should take corrective steps in the light of ‘evaluation’ as above and his assessment of his competitors. This step is a must in order to survive and thrive.
Needless to say, this article attempts to help MSMEs, who may not afford high level finance people to check multiple ratios (which are complex) in a sophisticated manner. Only the businessman who evaluates his performance and take corrective action will survive in today’s competitive world. Rest can be seriously affected ………. today or tomorrow.
The columnist is a senior chartered accountant. He is Chairman of Indo-American Chamber of Commerce, Goa; and Director of EDC, Goa. Email: srkgoa@gmail.com
