How Well is Your Company Performing

This post concerns financial management.

A key responsibility of the CFO is to understand how financial ratios reflect the firm’s quality and performance. Most often, the CFO is approaching this duty from the perspective of capital providers by examining financial statement ratios. However, there are other financial ratios, often not discernible from the financial statements, the CFO must evaluate. These measures are derived from internal financial data and provide insight as to how to improve operational performance to drive returns.

The contribution margin measures the incremental profit for each unit sold. The profit is used to cover fixed costs with the remainder flowing to operating profit. Contribution margin is calculated as (Sales – Operating expenses) / Sales. This measure can be used to determine how much profit growth the firm can generate once fixed costs are paid.

The contribution margin can also be used for pricing decisions. Typically, a low contribution implies the need for high volume driven by a low price. Likewise, a high contribution margin, driven by a high price, implies positioning the product as a premium brand. Performing a sensitivity analysis by calculating the contribution under various price and volume combinations can provide important pricing decisions.

Finally, the contribution margin is helpful in forecasting the change in profitability based on a change in volume or pricing strategy. Thus, it is an effective tool for strategic tool for strategic and tactical planning.

The break-even point depicts the sales volume at which the firm earns almost exactly no profit. It is calculated as (Total Fixed Expenses) / Contribution Margin. The calculation excludes such fixed expenses as depreciation and amortization as they are non-cash expenses. A key use of this measure is to model scenarios at which various combinations of product sales will trigger a loss.

The margin of safety represents the reduction in sales that can occur before the business reaches its break-even point. The calculation is: (Current Sales – Break-even Point) / Current Sales. This ratio helps management gauge the risk of losing money for given sales decline. It also helps management understand how well the firm is protected from variations in sales volume.

The CFO’s knowledge of the components of these measures provides operating managers with the tools and information necessary for making optimal business decisions regarding marketing, sales, product lines, and cost management. Some examples include:

•Use the Contribution Margin to compare different profit centers and thus where to focus efforts on increasing sales or reducing costs.
•Use the Margin of Safety to determine how much sales volume is required for the entrepreneur to be confident about opening a new branch, business unit, store, or adding a new product line.
•Use Break-even Point to determine how long it will take a new venture to break even and whether the time frame makes it worthwhile to assume the attendant risks.
A key responsibility of the CFO is to understand how financial ratios reflect the firm’s quality and performance. Most often, the CFO is approaching this duty from the perspective of capital providers by examining financial statement ratios. However, there are other financial ratios, often not discernible from the financial statements, the CFO must evaluate. These measures are derived from internal financial data and provide insight as to how to improve operational performance to drive returns.

Capitol CFO Solutions serves clients in Washington, D.C., Maryland, and Virginia. Please contact us for a free consultation.