How to review profitability ratio formulas
Most commonly, profitability ratios measure gross profit margins, operating profit margins, and net profit margins. To understand why these ratios are useful, consider a plumbing business.
If a plumber generates $300,000 in sales a year, their goal is to maximize earnings (profit) generated from sales. Margin ratios explain how well the plumber generates profits from each dollar of sales.
The plumber owns a $20,000 truck and $5,000 in equipment. How much profit could the plumber generate by using the $25,000 in assets? If the plumber invested $40,000 to start the business, how much profit could they earn on his investment? We can answer these questions using return ratios.
How to use the gross profit margin formula
Gross profit is total sales subtracted from the cost of goods sold. The cost of goods sold balance includes all costs that are related directly to the creation and sale of a product or service. Gross profit is stated as a dollar amount. The gross profit margin is expressed as a percentage. The gross profit formula follows:
(Total revenue – the cost of goods sold) / total revenue
Note that the gross profit margin uses revenue instead of sales. Premium’s revenue includes $1,000,000 in sales and a $2,000 gain on sale. Using the formula, we find Premium’s gross profit margin is 40.1%. The formula follows:
($1,002,000 – $600,000) / $1,002,000 = 40.1%
The gross profit margin is an important metric because, often, the cost of goods sold is a company’s largest expense. Premium earns slightly over 40 cents for each dollar of revenue. This ratio tells the business owner how well they’re minimizing the cost of goods sold. The business’s operating profit margin (or operating margin) includes more expenses.
How to use the operating profit margin formula
The operating profit margin formula divides operating profit and total revenue. It explains a company’s ability to generate a profit from normal business activities. The formula follows:
Operating profit / total revenue
Non-operating activities are not generated from normal business operations. Premium manufactures cabinets, so selling a piece of equipment is not Premium’s main business. Paying interest on a loan is also a non-operating activity. Using the operating profit margin formula, Premium finds its margin is 19.9%. The formula follows:
$200,000 / $1,002,000 = 19.9%
The operating profit margin is lower than the 40.1% gross profit margin. As the income statement indicates, operating profit includes $200,000 in expenses that are not included in gross profit. Meanwhile, the net profit margin generates a lower profit percentage than the operating profit margin.
How to use the net profit margin formula
The net profit margin formula divides net income by total revenue. Net income includes all income and expenses, including taxes. The formula follows:
Net income / total revenue
Premium’s net income includes interest expenses and tax expenses. Using the net profit margin formula, Premium finds its margin is 13.8%. The formula follows:
$138,000 / $1,002,000 = 13.7%
Generating cash inflows is just as important as earning a profit. Many profitable companies struggle to collect enough cash to operate the business each month.