EM3093 - Examining Accounts: Business Ratios: Net Profitability to Turnover

From the proprietor’s point of view, the most vital indicator to the success of the business is what is left at the end of the day. The efficiency of the business and the wisdom of any commercial decisions which have been taken must be judged ultimately by the criterion of whether or not they have made the proprietor wealthier. It can be worth looking at the proportion of turnover which accrues to the proprietor or directors and seeing how this has changed over the years. The ratio is:

• Non-incorporated Business - Net Profit x 100 / Turnover
• Companies - Net Profit and Directors’ Remuneration and Directors’ Pension X 100 / Turnover

What is accruing to the trader, and in company cases, directors’ (including pension payments).

• Does the result make sense? In a high turnover retail trade you would expect to see a very low ratio, but a similar figure would be disastrous in a capital intensive business with a slow turnover of goods.
• How has the ratio changed over the years? If, for instance, turnover has been increased, but gross margins were squeezed to achieve this one would expect to see net margins at least holding steady. If there has been a decline in net margins then additional risk is being taken for little reward. This will be especially true if additional assets have had to be bought, as they must be paid for out of the net profit.

When looking at this ratio, it must be remembered that the effect of evasion will be much more marked than on the gross profit ratio. The net profit is a smaller figure and will reflect evasion linked to expenses as well as any in the trading account (sales and purchases).