Profitability is one of the most significant parameters to measure the financial performance of your business. It is nothing but the capacity of your business to earn profits in the normal course of its operations. The term profitability is different from the profits earned by your business.
Profits refer to a situation when the value of your businesses’ output exceeds the cost of its input. Whereas the term profitability refers to the ability of your business to earn a return on a given investment.
Thus, profitability is the primary goal of all business ventures. No business can survive in the long run without profitability.
Therefore, a business that has higher profitability:
- has the capacity to reward its owners with a greater return on their investment,
- is operationally efficient,
- has the capacity to meet its short-term obligations, and
- indicates the public acceptance of its product and its competitiveness
There are various ways of measurement of profitability. These include calculating profitability ratios, undertaking breakeven analysis, and determining return on assets and investments. In this article, we will discuss all you need to know how to undertake profitability analysis of your business including how to calculate profitability and profitability formulas.
How to Measure the Profitability of Your Business?
Profitability is a tool to plan and monitor the profits your business earns. Your business can figure out a breakeven point, the number of products you must sell at a given price, profit margin, and sales volume with the help of profitability analysis.
On one hand, the profitability calculations help you to analyze realistic price levels, profit margin as well as sales revenue. On the other, the breakeven point provides the sales target for your business.
Make sure that your basic financial statements including income statement and balance sheet are complete before you undertake the measurement of profitability of your business.
Thus, the most commonly used ways for undertaking profitability analysis include:
Margin or Profitability Ratios
Profitability ratios refer to the financial metrics used to assess your business’s ability to generate earnings as against its revenue, operating costs, assets, or shareholder’s equity.
These ratios indicate how well your business makes use of its resources to generate profits and create value for its shareholders. Furthermore, businesses generally seek higher profitability ratios as it typically means that the business is performing well in terms of generating revenues, profits, and cash flows.
Profitability Ratios are most useful when they are compared to your business’s past financial data, your industry’s average ratios, or ratios of similar companies.
Now, profitability ratios are further divided into two categories:Margin Ratios and Return Ratios. This section covers margin ratios.
What are Margin Ratios?
Margin Ratios are one of the most commonly used profitability ratios. These provide insights about the ability of your business to convert sales into a profit.
In other words, margin ratios indicate what percentage of your company’s sales has converted into profits.
Or, simply put, the percentage figure of the margin ratios report the cents of profits your business has earned for each dollar of sale.
For example, your business earns a net income of $0.20 for each dollar of sale if it reports a profit margin of 20%.
Generally, margin ratios are used by stakeholders like creditors, investors, and business owners to understand a business’s financial health and growth potential. Following are the various margin ratios:
Gross Profit Margin Ratio
Gross Profit Margin is nothing but the gross profit as a percentage of net sales. It is also referred to as Gross Margin Ratio.
Gross Profit refers to the profit left after the cost of goods sold is subtracted from net sales.
The Cost of Goods Sold, also known as the Cost of Sales, is the price your business pays for the products it sells during a given accounting period. It refers to the direct costs of goods your business manufactures.
These costs include the cost of materials and labor directly used to produce the goods. However, COGS excludes indirect costs and expenses like sales and marketing and overhead.
The Formula for Gross Profit Margin
Gross Profit Margin = (Net Sales – COGS)/Net Sales
What Does Gross Profit Margin Ratio Indicate?
Gross Profit Margin Ratio is an important indicator of your company’s financial health.
An adequate Gross Margin indicates that your business has the capacity to pay its operating and other expenses as well as growth potential.
It is an important measure of your business’s profitability as it looks at your business’s major inflows and outflows of money: sales, money inflow, and cost of goods sold, and money outflow.
Furthermore, your business’s Gross Profit Margin should be stable and not fluctuate from one period to another.
The fluctuations can be justified in case your industry is undergoing changes, impacting your COGS, and the pricing policy.
Net Profit Margin Ratio
Net Profit Margin ratio is the profitability ratio that indicates the amount of net profit your business generates from its total revenue. It is nothing but net profit as a percentage of net sales.
The net profit margin ratio is generally expressed as a percentage. However, it can also be represented in decimal form.
Simply put, the net profit margin ratio indicates how each dollar earned in revenue gets converted into profit.
The net profit margin ratio is also known as the net margin. Here, net profit refers to the net income represented on the income statement of your business.
The Formula for Net Profit Margin
Net Profit Margin = [(Revenue – COGS – Operating and Other Expenses – Interest – Taxes)/ Total Revenue] x 100
As indicated in the above formula, the net income is calculated as sales minus:
- Selling, General, and Administrative Expenses,
- Operating Expenses,
- Taxes, and
- Other Expenses
Thus, net income is an important financial metric that investors consider useful as it helps them to analyze the extent to which your business’s revenue exceeds its expenses.
What Does Net Profit Margin Ratio Indicate?
The Net Profit Margin Ratio is another vital profitability ratio indicating your business’s financial health.
It is essential to keep a check on the increase and decrease in your business’s net profit margin.
This is because such an assessment would help you to know whether the current systems and procedures are working correctly or not.
You can even compare your business’s net profit margin with that of two or more businesses as the net profit margin is expressed as a percentage.
Besides this, stakeholders such as investors can evaluate whether your business is generating sufficient profit from its sales.
Furthermore, they would also determine whether the operating cost and overhead expenses are controlled or not.
Operating Profit Margin Ratio
Operating profit margin is a profitability ratio that indicates how much profit your business generates from its core operations.
It measures the amount of profit your business generates on a dollar of sales. This is calculated after deducting variable costs of production like raw materials and wages, but before considering interest or tax.
So, your business’s operating income is divided by its net sales to calculate the operating margin ratio.
Operating income is the same as earnings before interest as taxes and is used in calculating operating margin.
The Formula for Operating Profit Margin
Operating Profit Margin = Operating Earnings/Revenue
Operating earnings are nothing but Earnings Before Interest and Taxes (EBIT). And EBIT is revenue minus:
- COGS and
- Selling, General, and Administrative Expenses Excluding Interest and Taxes
What Does Operating Profit Margin Ratio Indicate?
This ratio indicates your company’s operating efficiency, management skill, and the riskiness of your business.
It showcases the proportion of revenues available to meet non-operating expenses such as interest.
Thus, investors, as well as lenders of your business, keep a close track of the operating margin of your business.
A highly fluctuating operating profit margin ratio indicates the riskiness of your business.
Thus, better management can improve the operating margin of your business.
Break-even is a point where your business expenses equal your business revenues. This means that your business is running into losses until it reaches its break-even point.
In other words, the costs for your material, labor, rent, and other expenses are greater than your gross revenues when your business is yet to reach its break-even.
However, your business revenues exceed expenses once you cross the break-even point. This means that a dollar of sales generated contributes to your business profits after the break-even point. It is after the break-even point that your business starts generating profits.
Accordingly, break-even analysis is a simple tool. It helps you to determine the relationship between your business revenue, product costs, and the sales volume.
So, it is extremely beneficial to evaluate your business’s break-even point. This is because it tells you if your business is generating profits or running into losses. In case your business generates profits, it lets you know the amount of buffer you have should your revenues decline. However, if your business is running into losses, your buisness’s break-even point would indicate how far your business is from earning profits.
In addition to this, you can use break even analysis for assessing future profits. Let’s try to understand how break even point is calculated for sales and for units sold.
Break-Even Analysis for Sales
You should estimate the following components in order to calculate the break even point for your business sales.
Fixed expenses are expenses that do not vary with change in your business sales. These are the day-to-day expenses that your business incurs irrespective of the sales volume increasing or decreasing.
Examples of fixed expenses include salaries, rent, office expenses, depreciation, etc.
Variable Expenses Expressed as a Percentage of Sales
Variable expenses are the variable costs that vary with the change in the level of your sales.
This means these expenses increase with the increase in the level of sales and decrease when the sales volume declines.
Examples of variable costs include cost of goods sold, salaries for sales personnel, over time wages, etc.
Hence, you can undertake breakeven analysis for your business using the above information.
Then, you need to use the following formula to calculate your business’s break even point. This you can do after calculating fixed expenses, variable expenses, and sales.
Break Even Point for sales = Fixed Expenses + Variable Expenses (expressed as a percentage of sales)
As it is clear from the above formula, Sales at the break even point are equal to the expenses. This means that no profits have been recorded at the breakeven point.
However, the next dollar of sales earned would contribute to profits.
Break Even Analysis for Units Sold
It is beneficial to calculate the breakeven point in terms of the number of units sold depending on the type of your business.
In other words, it is useful to calculate the number of units which must be sold to reach the breakeven point.
The following is the formula for calculating the breakeven point for the units sold.
Break Even for the Units to be Sold = Fixed Expenses/(Per Unit Sales Price – Per Unit Variable Expenses)
It is clear from the above formula that you need to calculate two new components:
- Per Unit Sales Price
- Per Unit Variable Expense
Break Even Analysis for Planning Profit
You need to make a small adjustment to the formula for the break even analysis to plan for your business’s profitability. Such a measure will help you to understand how you can attain a given level of profit in the near future.
Therefore, you can easily calculate the amount of sales required to achieve a net income before taxes. All you need to do is add the amount of net income you want your business to earn in the following formula:
Sales at Break Even Point = Fixed Expenses + Variable Expenses as a percentage of Sales + Desired Net Income
Return on Assets and Return on Investments
Return ratios indicate your company’s ability to generate returns for its shareholders. These ratios typically compare a return metric with certain balance sheet items. The commonly used return ratios include return on assets, return on equity, and return on investments.
Return on Assets
Return on assets ratio is a profitability ratio that indicates the profitability of your business compared to its total assets.
This ratio measures the relationship between the profits your business generates and the assets that are being used.
Thus, the return on assets ratio indicates the efficiency with which your business utilizes its assets.
Accordingly, the higher the return, the more productive and efficient your business is in utilizing its economic resources.
Though comparing profits to revenue is a good way to assess the operational efficiency of your business.
However, comparing profits to your business’s assets or resources utilized to earn such profits indicates the likeliness of your company’s existence.
Return on assets is calculated by dividing your business’s net income with total assets.
Formula For Return on Assets
Return on Assets = Net Income After Tax/ Total Assets
Here net income is nothing but sales minus COGS, selling, general, and administrative expenses, depreciation, interest, taxes, and other expenses.
What Does Return On Assets Indicate?
Return on assets is a profitability ratio that indicates your business’s ability to generate profits before leverage.
Accordingly, such a ratio indicates the capital intensity of your business. Such a ratio gives an indication to the investors about the efficiency of a company to convert the money it invests into net income.
The higher the return on assets, the more favorable it is for your business. This is because such a number indicates that your business is earning more money on the lesser investment.
Return on Equity
Return on Equity is a financial metric that measures the financial performance of your business. It indicates the amount of net income earned as a percentage of shareholder’s equity.
Thus, ROE presents a total return on the equity capital of your business. That is to say, it showcases your business’s ability to turn equity investments into profits.
Also, you can compare your business’s ROE to the industry’s average and understand the competitive advantage of your business relative to the other firms in the industry.
Such a financial metric also gives insights with regards to the efficiency with which you are using equity financing to grow your business
Formula For Return on Equity
Return on Equity = Net Annual Income/ Shareholder’s Equity
The Net Income is nothing but the Sales minus the Cost of Goods Sold, Selling, General, and Administrative Expenses, Operating Expenses, Depreciation, Interest, Taxes, and Other Expenses.
Whereas, Shareholders’ Equity is your business’ total assets less total liabilities.
What Does Return On Equity Indicate?
Return On Equity (ROE) of your business indicates profitability of your business with respect to the Shareholder’s Equity for your business.
Now, a satisfactory or an unsatisfactory figure for ROE depends on the ROE considered normal for the industry or your competitors.
So, given this, a generic criteria that you can follow is to aim for an ROE that is equal to or just above the average for the industry or the competitors in your industry.
Return on Investments
Return on investment is a financial metric used to determine the efficiency of your business’s investment. It is a performance measure that compares the extent as well as the timing of gains from investment to the extent and timing of costs.
Thus, ROI is used as a tool to measure the profitability of your business’s investment. Such a return may include the return that your business expects to generate by expanding its operations on a stock investment or real estate.
ROI is typically expressed as a percentage rather than a ratio.
The Formula for Return on Investment
ROI can be calculated using the following methods:
Return on Investment = (Net Return on Investment/ Cost of Investment) x 100
Return on Investment = (Current Value of Investment – Cost Investment)/Cost of Investment
Here, the current value of an investment refers to the value obtained from the sale of the investment.
What Does Return On Investment Indicate?
A positive ROI figure indicates that the investment is worthwhile as the total return exceeds the total cost.
However, a negative ROI figure indicates that the investment has endured a loss as total costs exceed the total returns.
Thus, we can say that ROI is an important financial metric for decisions like the purchase of assets, approval, and funding for projects, and traditional investment.