Health Check: Measure Profitability

Author: Sanjeev Chib

Here’s the last set of ratios I will discuss in this series on conducting a health check of your company: Profitability ratios. There are various other types of ratios that we have not discussed here that you can also perform, if applicable to your business.

Now let’s look at “Profitability Ratios”.

What does it mean:
Profitability ratios provide a measure of how successful your travel business is in terms of generating commissions relative to sales or resources invested in the business.

Commission Margin Ratio (a.k.a. Gross Margin Ratio) measures how much commission your business is earning relative to the total gross sales of your business.

Commission Margin Ratio = Commission Earned / Gross Sales
(This information is available directly through the Sales Activity report in the Merang TravelOffice system – back-office module)

While this ratio gives you an indication of how much commission (on average across all suppliers) you are earning for each dollar of gross sales you make, it may also indicate how much of a discount you are providing. For example, if on average you earn 8% commission based on your agreements with suppliers, but you find that your commission margin ratio is only 5%, it indicates that you are on average giving a 3% discount on your sales. If in the following year, your ratio goes down to 2%, it indicates that you were forced to increase the amount of discounts – this could have been due to increased competition pressuring you to reduce your commissions even further, or perhaps suppliers are reducing their commission rates. If possible, try to set a target for your ratio, and creatively identify ways of meeting or exceeding this target.

Return on Assets measures how effectively your assets are being utilized to generate profits.

Return on Assets = Net Income / Total Assets

Return on Equity measures the profit earned for each dollar invested into the business by shareholders.

Return on Equity = Net Income / Shareholders Equity

As mentioned, there are various types of ratio analysis that can be performed. In this series, I’ve only focused on those that I felt are more applicable to the small to mid-size travel businesses. Feel free to google this topic on finanical ratios to learn about other types of ratios that we have not covered here.

Also, while these measures are useful in giving your business an overall health check, they do have limitations. As discussed in my last post, you should compare your results to historical values, industry-averages, and/or targets you have set. Factors of your specific business may result in the ratios not being meaningful, and so you should be cautious. But overall, these measures will probably provide a benefit to you and should be used to measure the health of your business on an ongoing basis.

Health Check: Get Your Assets Moving.

Author: Sanjeev Chib

Let’s get right to it. Previously we wrote about liquidity ratios, which provide good indications on how quickly you are able to pay off short-term debt, and hence how cash rich your company is. Now let’s look at “Asset Turnover Ratios”.

What does it mean:
Asset turnover ratios provide a measure of how efficiently your travel business utilizes its assets. Our focus here will be on Accounts Receivables ratios, which are very useful for travel businesses. Inventory ratios can also be calculated in a similar way, but as most travel businesses don’t carry inventory, we have excluded these.

Receivable Turnover Ratio measures how quickly you collect your accounts receivable. Generally, travel businesses have three sources of amounts receivable; amounts receivable from customers, commissions receivable from suppliers, and amounts receiable from your credit card processor (i.e. settlement). Calculating the Receivable Turnover Ratio on the first two (i.e. customers and suppliers) will provide a useful indication on how quickly you are collecting from these two sources.

For customers:
Receivables Turnover = Annual Credit Sales / Accounts Receivable

For Suppliers:
Receivables Turnover = Annual Gross Sales/ Accounts Receivable

To be useful, for the supplier receivables turnover, it is better to use the annual sales where commission is owing from suppliers – i.e. total gross sales for which the the supplier owes you commission, as opposed to cases where you collect the full amount from the customer and pay the supplier the net cost. However, most systems don’t provide such granular information and therefore getting the amount of “annual commission-owing sales” may not be possible. As an alternate, you could just use “Annual Gross Sales” instead. The idea is to take this measure and compare it against previous years ratios to see if you are getting better or worse.

Collection Period provides similar information to the receivables turnover ratio, but expresses it in number of days it takes to collect the amounts receivable (and therefore, may be more meaningful).

Average Collection Period = 365 / Receivables Turnover

Some points to note when using any of these financial ratios is:
* To be meaningful, you need a reference point against which to compare the result. Therefore, you could compare the results against the previous years for your business, or against other travel businesses. We are currently working on features/reports within the Merang TravelOffice system that will enable you to do both; compare against your historical ratios and compare against the general average ratios combining all our clients in the system (but not against any specific client).

Remember these are just indicators to get a pulse of the business.

Health Check: Taking the Pulse of Your Business

Author: Sanjeev Chib

At this time of year, many small businesses are busy preparing/finalizing their year-end 2008 financial statements for tax purposes, for submissions to other parties (e.g. regulatory bodies), and for some, to measure the state of their companies. Periodically monitoring the health of your business is always a good practice, especially during these recessionary times. It may give you some real insights into your business, help you identify any problem areas and focus and plan for the future.

We’ve put together some key “health check” indicators that you can easily calculate which will enable you to take a pulse of your business, which we will discuss over the next few series of posts. The numbers used in the following calculations can be obtained from your financial statements, and in many cases from the reports you create in the Merang TravelOffice system. This is not an extensive list of all financial ratios available (you can do a google search to get more) but just some basic ones we thought would be useful.

Let’s get started with “Liquidity Ratios”.

What does it mean:
They are a set of calculations (financial metrics) that will give you an indication of your company’s ability to meet short-term debt obligations. Basically, this is done by comparing your company’s ‘liquid’ assets (i.e. cash, or those easily converted to cash, such as short term investments, accounts receivable, and other ‘current assets’) to your short-term (or current) liabilities. This information is available on your balance sheet.

Generally, the higher the value of the ratios means that your company has a larger margin of safety to cover these short-term debt obligations (i.e. the “healthier” you company is). A higher value means that you will be able to pay your short-term debts as they come due. A low value means that you will have a more difficult time paying your short-term debts and meeting the running/operating costs of your business.

We will present here three types of liquidity ratios:current ratio, quick ratio, and cash ratio:

Current Ratio measures the short-term solvency of your business.

Current Ratio = Current Assets / Current Liabilities

Quick Ratio is a measure of your company’s ability to pay short-term debts instantly.

Quick Ratio = (Cash + Accounts Receivable) / Current Liabilities
-OR-
Quick Ratio = (Current Assets – Inventory) / Current Liabilities
(as travel businesses probably would not have any inventory, the first calculation is more useful).

Cash Ratio is very similar to the quick ratio, except it only includes cash or cash equivalents (e.g. short-term or marketable investments) in the calculation. It is again a measure of the ability to pay off short-term debts immediately, but is more conservative than the Quick Ratio.

Cash Ratio = (Cash + Marketable Securities) / Current Liabilities

Again, there may be other Liquidity ratios that you could also use. But we hope you find these basic ones useful. Over the next few posts, we will provide some other types of ratios that you may be able to use.