I have believed for years that it is important for ProAdvisors to know more than just how to enter transactions into QuickBooks. ProAdvisors should be able to not only produce the financial reports from QuickBooks, but should be able to interpret those financial reports and what they mean about the financial condition of any business. I believe this now, and I believed it several years ago when I worked as Technical Editor with a very smart guy by the name of Conrad Carlberg on a book titled “Business Analysis for QuickBooks” (by Wiley Publishing)1. Conrad was a leading author on textbooks for Microsoft Excel and the majority of our book covered how to pull data out of QuickBooks (via export as well as the SDK) and manipulate that data within Excel to produce various business measures that QuickBooks simply doesn’t provide. Among those measures were the kind of Business Analytics that most ‘big businesses’ consider essential, but most small businesses owners simply don’t know about, understand or begin to have a clue how to prepare.
I will tell you that our textbook was NOT a ‘best seller’ in fact I may have purchased more copies myself than otherwise sold in the local bookstore. The reason, most people using QuickBooks simply don’t believe they need to spend the time or effort to produce analytics for their small businesses. When they were asked by a lender to provide a ‘debt ratio’ they either “scratched their heads” and ignored the request (thus losing the loan) or they called a local CPA and paid them a few hundred dollars to take their data and compile the numbers for them.
But my purpose in getting involved in the textbook was not so much the ‘everyday user’ of QuickBooks, but ProAdvisors who I felt needed better education, in the skills and techniques needed to become a ‘trusted advisor’, than was provided in the ProAdvisor training programs at that time.
It appears that a lot of App software vendors thought that there was a need for the type of financial information which Business Analysis for QuickBooks instructed, because there has been a proliferation of Apps developed that can provide the same Business Analytics instructed in our text. It also appears that the recent emphasis on the role of ProAdvisors as trusted business advisors has led to the inclusion of ‘advisory services’ as part of the curriculum instructed and tested in the new QuickBooks Online ‘Advanced Certification’ program. A good portion of Module 5 of that curriculum reviews the basic information on Ratio and Trend Analysis as well as applying those measures against industry averages and benchmarks.
It is with this frame of mind that I have written this series of articles that provide conceptual principles covering Business Analytics expanding upon the cursory information contained in the new curriculum.
Introduction to Business Analytics
As ‘accounting would have it’, there are certain numbers from a company’s income statement and balance sheet which, when combined properly, can give a much clearer insight into how the company is performing, and far more so than just the raw figures. These combinations take the form of ratios, and most of these ratios are designed to give you clear indicators of how the business is performing, areas needing attention, and things the business seems to be doing great with.
Many of these ratios are of interest for different purposes, and they also tend to be based upon the responsibilities that different individuals may have within a business. For example, while almost everyone involved with a company should have an interest in how the company is performing as measured by its ‘return on assets’, the company’s management will have a keen interest in the ‘operating expense ratio’. The creditors of a business tend to have a special interest in a company’s ‘debt ratio’, while Inventory Managers will likely be most interested in the ‘inventory turns ratio.’
The problem with businesses that use QuickBooks for their financial/accounting software, by itself, is that almost NONE of these critical measures can be produced from the software itself. Yes you heard me correctly, QuickBooks, the number one small business accounting software on the planet, cannot provide these critical measures by itself. Now with that said let me interject that if you are running QuickBooks Enterprise there are a limited number of ratios that can be reported using the Financial Statement Designer ‘add-in’ tool (FSD), but a lot of QuickBooks Enterprise users are not aware of FSD, and even a lot of ProAdvisors are not versed in the use of FSD.
As I mentioned earlier, during my involvement in the preparation of Conrad’s book, my thinking was that QuickBooks ProAdvisors who read, and learned the concepts instructed therein, would be armed with the necessary knowledge to be able to offer ‘business analyses’ to their clients. But based upon the sales of the book there are darn few copies of it sitting on the shelves of QuickBooks ProAdvisors, and today while you can still purchase copies of the text from the Amazon marketplace, the variety of Apps I mentioned earlier make manual computations almost a nonsensical endeavor. But even though these Apps can compute the various business analytics in milliseconds from a company’s QuickBooks data, ProAdvisors still need to have a fundamental understanding of the concepts (and computations) behind these various numbers, as well as in the interpretation of these measures, and in relating them to similar businesses as well as the business on a historical perspective.
So with my copy of our textbook in hand, I intend to discuss these critical business analysis measures over a series of articles, beginning with this article on “Profitability Ratios”. These measures are intended to reflect the key components shown on the QuickBooks Profit and Loss Report, which for most purposes corresponds to an ‘Income Statement’.
Gross Profit Margin Ratio
The gross profit margin ratio is an expression of the gross profit as a proportion of income. (Note some definitions use the term ‘sales’ in lieu of ‘income’; however we are using income because of the differences in these terms as defined by QuickBooks. In QuickBooks Income is a figure generated from all ‘revenues’ recorded; however, Sales represent only those ‘revenues’ posted as income from “QuickBooks’ items”.) The gross profit margin ratio is computed as:
Gross profit margin ratio = gross profit ÷ income
The gross profit margin ratio is a good indicator of the financial health of a business because it measures the efficiency of a business in using its materials and labor in the production process and gives an indication of the pricing, cost, and production efficiency of the business. Using this ‘analytics’ the higher the gross profit margin ratio the better the business is doing.
Higher percentages mean the business is retaining more of each dollar of sales, resulting in more funds being available for other operating expenses and net profits. Low gross profit margin ratios mean that a business is producing a low level of revenue to pay for operating expenses and net profits, in these circumstances either the business is unable to control production and/or inventory costs or their sales prices are set too low.
Now some might counter saying that “our business is not in production, we are only a service company.” But even service companies should have gross profit if they are properly reporting their direct costs of producing service income as ‘cost of sales’ (which means that they would be posted in one or more COGS accounts within QuickBooks). I think Michelle Long gave an excellent example of this in the training materials for the QuickBooks Online Advanced ProAdvisor certification, so I will simply quote her: “For example, airlines are primarily a service-based business. Cost of sales may include the salaries for the pilots and attendants, airplane fuel and maintenance, etc. Cost of sales would include the direct/variable costs associated with making the sale or providing the service.”2
The related datametric is the gross profit margin which is the gross profit margin ratio expressed as a percentage:
Gross profit margin (%) = (gross profit ÷ income) x 100
Net Profit Margin Ratio
The net profit margin ratio is net profit as a proportion of sales; this ratio shows the proportion of every dollar of income (sales) that is left after all expenses have been paid, and remains as net profit. Because net profit is used to pay for interest, tax and distributions to the owners, the higher the net profit margin ratio the better. The Net Profit Margin is computed as:
Net profit margin ratio = net profit ÷ income
High net profit margin ratios demonstrate the effectiveness of a business in converting sales into profits. Low net profit margin ratios can mean that a business is not generating sufficient sales, or that the gross profit margin is too low. In some cases it can mean that the business is not keeping its operating expenses under control so as to produce an acceptable profit. A trend of decreasing net profit margin ratios over time tends to indicate that a business is primer for significant efficiency improvements; this is probably one area that an astute ProAdvisor may be able to assist a business.
The related datametric is the net profit margin which is the net profit margin ratio expressed as a percentage:
Net profit margin (%) = (net profit ÷ income) x 100
Operating Profit Margin Ratio
Operating income is often referred to as earnings before income and taxes; it is also known by ‘accountant types’ using the acronym EBIT. It represents the income that is left on the income statement, after all of the operating costs and overhead including selling costs, costs of goods sold and administration expenses are subtracted out. The operating profit margin ratio is calculated as:
Operating profit margin ratio = Operating Income ÷ Income
The operating profit margin ratio provides significant information about a businesses’ profitability, particularly as it regards cost control efforts. A high operating profit margin usually indicates that a business has a low-cost of operations. This ratio means that the company has good cost controls, or that sales are increasing faster than costs, which an optimal situation for a business to find itself in. Operating profits will be significantly lower than gross profits since selling, administrative, and other expenses are included along with the cost of goods sold. As a company grows and sales revenue increase, the businesses’ overhead or fixed costs should ideally become a smaller percentage of total costs and operating profit margin ratios should increase.
The related datametric is the operating profit margin which is the operating profit margin ratio expressed as a percentage:
Operating profit margin (%) = (Operating Income ÷ income) x 100
It’s one thing to look at an Income Statement and notice that the company had net income of $100,000 during the last fiscal year, but it’s quite another to find out that the net income would have been $200,000, or more, if the company had a better grasp on their cost of sales. Ratios such as Gross Profit Margin, Net Profit Margin and Operating Profit Margin are intended to give you the proper context from which you can evaluate the raw dollar figures, thus placing yourself in the position to serve as a trusted business advisor.
In part 2 of this series we will examine Liquidity Ratios, their computations and meanings as well as the implications of each.
1 - Business Analysis for QuickBooks, Conrad Carlberg, Author, William “Bill” Murphy, Technical Editor; Wiley Publishing, 2009.
2 – QuickBooks Online Advanced Certification Course Supplemental Guide – Module 5: Advisory Services; Michelle L. Long, Author; Intuit, Inc., 2014.