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Running a business

4 ways to calculate profitability measures for your business

For most business owners, profitability is one of the primary goals. Your business is profitable if your revenue covers your expenses. Profit means positive cash flow, and positive cash flow helps keep your business operating.

This is all straightforward information. But if you run a profitable business, do you understand what makes your business profitable? Do you have a good idea if your profitability is sustainable?

When it comes to measuring profitability, there's more to it than simple profit. This article explains how to calculate profitability using four ratios so you can better understand your business. 

1. Margin or profitability ratios

An illustration of the top three ways to measure profitability, including profit margin ratios, break-even analysis, and return ratios.

Your margin ratios, also known as profitability ratios, tell you if you're running a profitable business.

To determine your margin ratios, you'll first need to run three calculations with numbers from your income statement. These include:

  • Gross Profit = Net Sales - Cost of Goods Sold (COGS)
  • Operating Profit = Gross Profit - Operating Expenses
  • Net Profit = (Operating Profit + Other Income) - (Other Expenses)

Each of these equations provides you with a way to express profit from a dollar perspective.

Just because a company earns more profit doesn’t mean it’s financially healthy—margin ratios are a better predictor of health and long-term growth than mere dollar figures.

The next step is to turn these calculations into ratios. Ratios are useful because they're a better predictor of health and long-term growth than a simple dollar figure.

Here are three ratios you can use to get a more accurate understanding of the inner workings of your business.

Gross profit margin ratio

Your gross profit margin ratio measures what percent of your selling price is a profit.

Gross Profit Margin = (Gross Profit/Sales) x 100

Let's look at a simple example. Say you run a cleaning company. Your business makes $10,000 cleaning houses, but you spend $5,000 on cleaning supplies.

Step 1: Gross Profit = Net Sales - COGS

$20,000 - $5,000 = $15,000 in gross profit

Step 2: Gross Profit Margin = (Gross Profit/Sales) x 100

($15,000/$20,000) x 100 = 75%

This tells you that out of every dollar you make cleaning houses, 75% of it is a profit after covering your costs.

Operating profit margin ratio

While gross profit margin ratio looks at profitability, it doesn't consider all of your operating costs.

Your operating profit margin ratio takes into account the cost of your cleaning supplies as well as other operating expenses, like the cost of advertising and marketing, insurance, or hiring an employee to help you keep up with your clients.

Operating Profit Margin Ratio = (Operating Income/Sales) x 100

Let's say you spend another $3,000 per month on operating expenses.

Step 1: Operating Profit = Gross Profit - Operating Expenses

$15,000 - $3,000 = $12,000 operating profit

Step 2: Operating Profit Margin Ratio = (Operating Profit/Sales) x 100

($12,000/$20,000) x 100 = 60%

Your operating profit gives you an idea of how efficient your company is. You can use this number to compare your business to your competitors in the industry.

This is also the best ratio to measure the ability to turn sales into pre-tax profits.

If you find your operating margin is stagnant over time, this can indicate an increase in operating expenses.

Net profit margin ratio

Net profit margin, also referred to as "profit margin," is the big-picture view of your profitability.

Certain industries such as banks, insurance companies, and real-estate companies tend to have sky-high profit margins, while other industries are more conservative.

You can use standards in your industry as a benchmark. Comparing your net profit margin every year can help you evaluate your company's performance.

Net Profit Margin Ratio = (Net Profit/Sales) x 100

Your net profit margin ratio accounts for all of your costs. In addition to your operating costs, it also considers any interest or taxes.

Your net profit margin ratio tells you how much profit you have after considering all of your expenses, including paying off any debts or taxes.

Let's say you spend another $1,000 per month on debts and taxes.

Step 1: Net Profit = (Operating Profit) - (Other Expenses)

$12,000 - $1,000 = $11,000

Step 2: Net Profit Margin Ratio = (Net Profit/Sales) x 100

($11,000/$20,000) x 100 = 55%

This means your actual profit after taking care of your operating costs and all other expenses is 55%. 

2. Break-even analysis

Your break-even analysis is the point where your expenses and revenues are the same. You're not making a profit, but you're also not losing money.

Calculating your break-even point allows you to determine how much breathing room you have in case things go south.

As a business owner, it's important to plan for the unexpected. Perhaps you lose access to raw materials due to a natural disaster. Or one of your manufacturers suffers a warehouse fire and can no longer provide the goods you need.

Whatever the case, knowing your break-even point can help you determine what you can afford to lose before your company is no longer profitable.

You can calculate the break-even point for different components of your business. For instance, as a figure of sales:

Break-Even Point Sales = Fixed Expenses/Variable Expenses

You can also measure your break-even point against units sold:

Break-Even Point for Units Sold = Fixed Expenses/(Unit Sales Price - Unit Variable Expenses)

Running these figures allows you to determine how profitable you'll remain in the future if something were to happen to your company. 

3. Return on assets (ROA)

Another measure of profitability that you can take from your financial statements is the return on assets (ROA).

Your ROA is a measure of how well your business is turning its assets into profits. A higher ROA suggests that your business is using its assets in an efficient way to generate profits.

You can use the following formula to calculate your ROA:

Return on Assets = (Net Income Before Taxes/Total Assets) x 100

4. Return on investment (ROI)

Your return on investment (ROI) measures the profitability of an investment.

You want to make sure your ROI is at least as high as what you'd be earning in a risk-free investment, such as a high-yield savings account or certificate of deposit (CD) account. If not, you're better off putting your money into one of these accounts.

Your ROI is basically a measure of whether this is all worth it.

You can use the following formula to measure your ROI:

Return on Investment = Net Profit Before Tax/Net Worth 

An additional profitability measure

Another measure of profitability is the profitability index (PI), also referred to as the profit investment ratio (PIR). You can use this formula to assess the potential profitability of an investment relative to its costs.

For instance, as the owner of a house cleaning business, you might consider purchasing a new steam cleaner. With this new piece of equipment, you could add a new service to your cleaning business and potentially improve your efficiency.

The following equation shows you how to calculate the profitability index:

Profitability Index (PI) = Present Value of Future Cash Flow/Initial Investment

If your PI is greater than 1, the investment is expected to result in a profit. If you get an index lower than 1, you might want to reconsider the investment.

The PI tool is a useful way to weigh different investment opportunities.

How to calculate the profitability of your business

If you've ever wondered how to determine the profitability of your business, now you have four different ratios to help you come to an answer.

Successful business owners know that the company's ability to make money is not measured by how much money is in the bank. Instead, the true determination of financial health comes from an analysis of business activities.

By using reliable accounting tools, you can gain more insight into your company's profitability. Doing so can put you in a position to achieve and maintain success over the long term. Using the profitability formulas provided in this article is an excellent way to get started.

If you're ready to work smarter and turn your complex financials into easy-to-read reports, check out QuickBooks Advanced today!


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