R/E: Your Profit Quotient
I firmly believe in the principle of KISS — Keep It Seriously Simple. Why do we make business more complicated than it needs to be? We have profit margins with percents — gross and net. We have operating ratios for truck fleets and other businesses. People generally have enough trouble with multiplication and division without adding the complications of percents and negative numbers–whether they are in red versus black or put into parentheses. Let’s make it simpler.
Why make the math more complicated than it needs to be. Profit Margin in percent is ((Revenue-Expenses)/Revenue) x 100. It cannot exceed 100% and should be greater than 0. Less than zero, negative numbers, implies a loss. Many people have trouble with negative numbers. Gross Margin in percent is similar and is ( (Revenue-Cost of Goods Sold)/Revenue) x 100 40% gross margin is a good business, where the Price = Cost of Goods Sold x 1.67. Sounds simple enough, until you start talking with people to determine what they consider the “cost of goods sold.” You would be amazed at what businesses choose to include or exclude from the cost of goods sold with their business. You might think that Certified Public Accountants (CPA’s) could agree on this. Alas, I find this is not the case. And, why do we have to add in the complication of percentages? Do you know how many people have trouble calculating percentages or identifying what a percentage means?
EBIDTA has now become a common measure of a business. It stands for Earnings Before Interest, Depreciation, Taxes and Amortization. I have not found many people that understand this, let alone those that can pronounce it. But, this is not nearly as consistent a measure as you might think. It is a non-GAAP (Generally Accepted Accounting Procedures) measure that allows a greater amount of discretion as to what is or is not included. It’s a bit like the measure of unemployment–changing from time to time. It’s also not the same as cash flow.
Are you selling at a profit, or at a loss? A measure such as Price/Cost of Goods A ratio that is greater than 1 is a profit and less than 1 is a loss. 1.02 is grocery store pricing and 1.67 is a good business. Basically, it’s just the markup multiplier. This works well for loss leader products in retail, but not for most businesses. And, it only covers the product, not the overhead and all the other expenses of the business.
For some businesses, such as trucking fleets, they use a measure called operating ratio, which is the ratio of operating expenses to operating revenue. It’s pretty good, and close to what I am suggesting. But, the measure is less than 1 if profitable and lower is better. That’s not quite right for most brains. We humans tend to think that more is better, not less. In sports, with the exception of golf, higher scores are better than lower scores.
So, that brings me to my suggestion. Let’s use a simple ratio of Revenue/Expenses This measure is greater than 1 if profitable and less than 1 if unprofitable. Larger is better. No negative numbers. Seems simple enough to me and meets the KISS principle.