Most people understand the meaning of the word profitability, whether they are in business or not, more money coming in than going out, right? In reality, there is a lot more to profitability than that, this article will cover what you need to know, giving you an inside look at profitability and what it means for your small business.
If your sales revenue covers your expenses, then you’re making a profit. Without this positive cash flow, your business simply wouldn’t stay afloat. It could be said that profitability is one of, if not the primary goal of business owners, however, we believe that business owners need to look beyond the figures in black and white and understand why their business is profitable.
There are three main ways to determine whether your business is profitable and we will explore each one in this article.
First, we’ll look at everything you need to know about profitability analysis, in order to measure your profitability accurately and help predict your future profitability. To run your margin ratios, aka profitability ratios, you’ll need to do three calculations based on your income statement.
- Gross Profit = Net Sales – Cost of Goods Sold (COGS)
- Operating Profit = Gross Profit – (Operating Costs, Including Selling and Administrative Expenses)
- Net Profit = (Operating Profit + Any Other Income) – (Additional Expenses) – (Taxes)
These figures allow you to express profit financially, from a dollar perspective. Converting these figures into ratios can be useful, as generally speaking it is easier to carry out analysis and make quick comparisons with ratios than individual amounts. For instance, although you might have earned more money in one quarter from a dollar amount perspective, your company could have been doing better overall in a quarter where you had a higher gross profit margin. Similarly, comparing a retail company subject to seasonal rises and falls based on its best quarter, Q3, the holiday period, and its worst, Q4, January to March, wouldn’t tell you very much. It would be better to compare its Q4 figures from 2017, 2018 and 2019 for instance, or its Q4 with those of its two main competitors.
So, more profit doesn’t necessarily equal financial health and stability. Margin ratios are better indicators of a company’s financial position and their potential for long-term growth than basic figures.
Gross Profit Margin Ratio
As shown above, your total gross profit is your sales revenue minus your cost of good sold. Cost of goods sold refers to how much your company paid to sell products in a given period, its profit after deducting direct materials, direct labor, inventory and product overhead.
Gross Profit Margin Ratio = (Gross Profit / Sales) × 100
If your gross profit margin ratio is high, this means you are keeping a lot of profit in relation to the cost of your product. Ideally, this ratio should be quite stable, there shouldn’t be drastic fluctuation over the course of the year unless there are unusual industry-wide changes impacting your pricing or cost of goods sold.
Operating Profit Margin Ratio
The operating profit margin looks at your current earnings. Here, you do want increases, as this would be a positive sign that your company was doing well.
Operating Profit Margin Ratio = (Operating Income / Sales) × 100
This ratio measures efficiency, and with it you can easily make comparisons between your figures and those of your competitors.
Businesses are often faced with gradual (or not so gradual!) hikes in operating costs. This can make it difficult to improve on your operating profit margin ratio. One thing you can do in this case is perform a comparative analysis of your operating expenses, which is a side-by-side comparison of the percentages from two years of data or more. This calculation can be complex, but you can use an online accounting software like Kiwili to help you export the data. This way, you can track the biggest percentage changes over time easily, and look into the reasons behind the biggest increases.
Net Profit Margin Ratio
The net profit margin, aka profit margin, gives you a bird’s eye view of your profitability. Some industries are notorious for having sky-high profit margins, like pharmaceuticals for instance, while others are more conservative. Find out the benchmarks for your industry in order to assess your performance each year. It is important to do your research here.
Net Profit Margin Ratio = (Net Income / Sales) × 100
The net profit margin is pretty similar to the operating profit margin, except that it applies to earnings after taxes. It demonstrates how much profit can be extracted from your total sales.
You probably know what the term breaking-even means, you’re not making money, but you’re not losing money either, your expenses and revenue are the same. As a business owner, you should always have some funds set aside to protect your business in case of extraordinary circumstances. Be aware that you could for instance lose access to your materials or manufacturers, temporarily or permanently, at any time, for reasons beyond your control. In this case, you need to know how much you can afford to lose in the meantime, before you are no longer profitable and have to cease operations.
You can calculate the break-even point for individual areas of the business. For example, for sales the formula would be:
Break-Even Point Sales = Fixed Expenses + Variable Expenses
And for units sold:
Break-Even Point for Units Sold = Fixed Expenses ÷ (Unit Sales Price – Unit Variable Expenses)
The final two measures of profitability are the return on assets (ROA) and return on investments (ROI).
ROA shows the total revenue compared to total assets used. You can use this figure to make comparisons internally, or with other companies in your industry. The higher the ROA, the more efficient things are.
Return on Assets = (Net Income Before Taxes ÷ Total Assets) × 100
ROI shows how much you’re earning in comparison to investments you make. Measuring the profitability of your investments allows you to make sure you’re investing your money wisely.
Return on Investment = Net Profit Before Tax ÷ Net Worth
In conclusion, it could be said that it’s not what’s in the cash register at the end of the day that counts at all, but a company’s staying power and long-term profitability. Gain invaluable insight into your company’s profitability using Kiwili, our all-in-one accounting solution, and access key metrics such as profitability ratios, break-even analysis, ROA and ROI. By analyzing key metrics, business owners can learn more about the financial health of their company and whether their profitability is actually sustainable. Making calculations and comparisons can help you identify what is working well and what issues need to be addressed.
Now you’ve covered all there is to know about profitability, you’re ready for part two. Check out our next post, all about solvency and liquidity. What exactly is solvency and liquidity? And how is it different from profitability?