Finance Management
Finance Basics: Business Profitability (B)
What are measures of business profitability?
Posted: Apr 2009
<<< Previously on Finance Basics: Accounting for Inventory
BUSINESS PROFITABILITY
In this final section we will take a step back from the business at the point it has reached now and spend some time reflecting on the results achieved and the questions raised for the future.
Note: The exercise should be done before looking at the concepts for this section
DAY TEN
The last day of the test run dawns... JS decides to close the business for now and wrap up everything neatly, by:
• collecting all outstanding debts
• only selling for cash
At the end of the day he also decides to pay cousin half the money he owes for the equipment, or $750.
JS makes sure to let all his, by now regular, customers know that the best run lemonade stand in town will be back soon...
PROFIT RATIOS
Performance can be measured through financial ratios. Two of those frequently used in business are:
Return On Equity (ROE): the amount of return made from the shareholder's perspective
Accumulated profit/loss (over a particular time period)
ROE = -----------------------------------------------------------------------
Shareholders' investment
A ratio is useful for comparing performance over time or between companies.
Return On Sales (ROS): measures profit made on operations, not taking into account the means of financing.
Earnings bef. interest + taxes (over a particular time period)
ROS = -----------------------------------------------------------------------
Total sales revenue
VALUE CREATION
A profitable business generates wealth for those who have contributed financing to the business.
• interest payments to lenders who have contributed loan capital
• returns to shareholders who have contributed equity capital, in the form of
- dividends paid from profits, or
- an increase in value of their share in the company.
The economic value created by the company benefits many other stakeholders:
• customers
• suppliers
• employees
• government
FUTURE RETURNS
Looking at the future, there are many questions about the ability of the company to realise profits.
• Is the expected return comparable to other opportunities available?
• How does the expected return compare with the risks involved ?
• If the assets were sold, would the amount received cover the liabilities of the company ?
• Will the company be able to continue its profitable performance in the face of uncertainties and risks?
