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Your Net Margin is a Key Indicator of HealthIf you only have time to look at one ratio consistently, what should it be?Brian Hamilton, CEO of Raleigh, N.C.-based Sageworks Inc., is a frequent guest lecturer and writer in the finance industry. His firm develops software applications that aid financial professionals in communicating more effectively with their business clients. Q: What is the most important financial indicator for small business owners? A: Net operating margin, also known as net profit margin, is the best barometer of a company’s performance. This is net profit before EBITDA (earnings before interest, taxes, depreciation and amortization) divided by sales. The ratio tells how well a company converts revenue from core operations into actual profit—how many cents of profit it gets from every dollar of sales. Q: Why is that ratio important above others? A: The operating margin shows how well the company controls costs. In the long term it drives cash flow and the company’s ability to borrow. A rising net margin could signal falling costs, increasing efficiencies or booming prices for the company’s products. Conversely, falling margins may signal rising costs, ballooning inefficiencies or a big tax bill. I can’t ever recall working with a company that has failed but had a consistently healthy net margin. Q: What constitutes a healthy net margin? A: It is difficult to give a single optimal percentage because there are variations across industries. You should be looking at trends over time, not just once a year. Anything above a zero is a good starting point. At one time, 49% of publicly traded firms were losing money. A very generic standard might be 3%. Generally a high net margin (7% to 8% or more) is considered a competitive advantage. Q: What’s another use for the net margin information? A: The next step is to combine the net margin ratio with a cash flow statement, which is not the same as a balance sheet or income statement. An income statement tells how much product was sold. A cash flow statement shows where the money went. It shows a lender exactly how you’re going to afford loan payments or how you have used the funds from a previous loan before they approve an extension of a new one. Without the cash flow statement, you have an incomplete picture. Source: Wells Fargo Discuss it on SBE Forum >> |
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