How to Measure Profitability?

Four Ways To Measure Profitability And Grow Your Business

In this article, we’ll cover definitions for the following terms:

1. Margin or Profitability Ratios

• Gross Profit Margin Ratio
• Net Profit Margin Ratio
• Operating Profit Margin Ratio

1. Break-Even Analysis
2. Return on Assets and Return on Investments

Profitability is one of the most important parameters to understand if you’re measuring your business’s financial performance. At its core, profitability refers to your business’s capacity to earn profits from its standard chain of operations. Although similar to each other, profitability and the profits that your business earns aren’t the same thing.

Think of it like this: if your business is making a profit, then the value of your business’s output is exceeding its cost of input. Profitability, on the other hand, refers to your business’s ability to earn a return on a given investment.

Profitability is, therefore, the primary goal of all business ventures. No business can survive in the long run without stable profitability.

A business that enjoys 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
• Demonstrates a public acceptance of its products and competitiveness.

There are different ways you can measure your business’s profitability. These methods include calculating profitability ratios, break-even analysis, and returns on assets and investments.

Below, we’ll discuss everything you need to know to perform a profitability analysis for your business. We’ll also cover important information on how to calculate your profitability and profitability formulas.



How to Measure the Profitability of Your Business?

Profitability is a metric that lets you plan and monitor your business’s profits and improve your company’s financial performance.

On one hand, profitability calculations help you analyze realistic price levels, profit margins, and sales revenue. A break-even point, on the other hand, provides you with the sales target for your business.

Make sure that you complete your financial statements, income statements, and balance sheet before performing a profitability analysis for your business.

The most common ways to perform a profitability analysis include:

Margin or Profitability Ratios

Profitability ratios are financial metrics used to assess your business’s ability to generate earnings against its revenue, operating costs, assets, or shareholder’s equity.

These ratios indicate how well your business uses its resources to generate profits and create value for your shareholders. Businesses generally seek higher profitability ratios, since higher ratios typically mean that a business is performing well in terms of generating revenue, profit, and cash flow.

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.

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 and provide insight into the ability of your business to convert sales into a profit.

In other words, margin ratios indicate what percentage of your company’s sales have converted into profits.

For example, if your business earns a net income of $0.20 for each dollar sold, then you enjoy a profit margin of 20%.

Generally speaking, stakeholders such as creditors, investors, and business owners use margin ratios to better understand their business’s financial health and growth potential. Below Are the various margin ratios that stakeholders use:

Gross Profit Margin Ratio

Gross Profit Margin is the gross profit as a percentage of net sales and is also referred to as Gross Margin Ratio.

Gross Profit refers to the profit that’s left after the cost of goods sold is subtracted from net sales.

Cost of Goods Sold (also known as Cost of Sales, or COGS) is the price your business pays for the products it sells during a given accounting period and refers to the direct costs of goods your business manufactures.

These costs include the cost of materials and labor directly used to produce your goods. However, COGS excludes indirect costs and expenses like sales and marketing as well as 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.

A good Gross Margin indicates that your business can pay for its operating costs and other expenses.

Furthermore, your business’s Gross Profit Margin should be stable and should never fluctuate between accounting periods.

Fluctuations in Gross Profit Margin can be justified in case your industry is experiencing changes, impacting your COGS, and affecting your pricing policy.

Net Profit Margin Ratio

Net Profit Margin ratio is the value that indicates the amount of net profit your business generates from its total revenue and represents your net profit as a percentage of your 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 your business earns in revenue is converted into profit.

The Net Profit Margin Ratio is also known as the net margin. In this case, net profit refers to the net income represented on your business’s income statement.

The Formula ForNet 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:

• COGS,
• Selling, General, and Administrative Expenses,
• Operating Expenses,
• Depreciation,
• Interest,
• Taxes, and
• Other Expenses.

Net income is an important financial metric that helps you 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 track of your business’s net profit margin since it helps you know whether your systems and procedures in place are working properly for your business.

Additionally, stakeholders such as investors can use the Net Profit Margin Ratio to evaluate whether your business is generating sufficient profit from its sales.

It can also determine whether your operating cost and overhead expenses are properly controlled.

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 and is calculated after you deduct variable costs of production like raw materials and wages, but before you consider your interest or tax.

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 your business’s operating margin.

The Formula for Operating Profit Margin

Operating Profit Margin = Operating Earnings/Revenue

Operating earnings are your Earnings Before Interest and Taxes (EBIT). 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 that are available to meet non-operating expenses such as interest.

Thus, investors, as well as lenders of your business, keep a close eye on your business’s operating margin.

A highly fluctuating operating profit margin ratio indicates a high level of riskiness for your business.

Better management, therefore, can improve the operating margin of your business.

Break-Even Analysis

Break-even is a point at which your business expenses become equal to your revenues, which means that your business is experiencing losses until it reaches its break-even point.

In other words, when the cost of goods, labor, rent, and other expenses are greater than your gross revenue, your business has not reached its break-even point.

However, your business revenues exceed expenses once it crosses their break-even point. This means that a dollar of sales generated contributes to your business profits after it reaches its break-even point. After you reach your break-even point, your business starts generating profits.

Break-even analysis is a simple tool that helps you determine the relationship between your business revenue, product costs, and sales volume.

It is, therefore, extremely beneficial to evaluate your business’s break-even point, which tells you if your business is generating profits or experiencing losses. In case your business generates profits, your break-even point lets you know the amount of buffer you have in case your revenues decline.

If your business is experiencing losses, your break-even point should indicate how far your business has to go before it starts earning profits.

Additionally, you can use break-even analysis to assess your future profits. Let’s review how the break-even point is calculated for sales and units sold.

Break-Even Analysis for Sales

You should estimate the following components to calculate the break-even point for your business sales.

Fixed Expenses

Fixed expenses are expenses that do not vary as your business’s sales change. Fixed expenses are the day-to-day expenses that your business incurs regardless of whether your sales volume is increasing or decreasing.

Examples of fixed expenses include salaries, rent, office expenses, and depreciation.

Variable Expenses Expressed as a Percentage of Sales

Variable expenses are the variable costs that vary with the change in your business’s sales levels.

These expenses, therefore, go up as sales levels increase and go down when your sales volume declines.

Examples of variable costs include the cost of goods sold, salaries for sales personnel, and overtime wages.

Sales

You can perform a break-even analysis for your business using the above information.

Afterward, you should use the following formula to calculate your business’s break-even point, which you can do after calculating your fixed expenses, variable expenses, and sales.

Break-Even Point for sales = Fixed Expenses + Variable Expenses (expressed as a percentage of sales)

As the above formula demonstrates, sales at the break-even point are equal to your expenses, which means that no profits have been recorded at the break-even point.

However, the next dollar of sales earned would contribute to profits.

Break-Even Analysis for Units Sold

It’s a good idea for your business to calculate its break-even point in terms of the number of units sold, depending on your business type.

In other words, it is useful to calculate the number of units that must be sold to reach your break-even point.

The following formula is used to calculate the break-even point for your units sold.

Break-even for the Units to be Sold = Fixed Expenses/(Per Unit Sales Price – Per Unit Variable Expenses)

As the above formula demonstrates, 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 above formula for the break-even analysis to plan for your business’s profitability.

Doing so can help you understand how to attain a certain level of profit in the near future.

Therefore, you can easily calculate the number of sales required to achieve a net income before taxes. All you need to do is add the amount of net income you expect to earn by using the following formula:

Sales at Break-Even Point = Fixed Expenses + Variable Expenses as a percentage of Sales + Desired Net Income

1. 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 most 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.

The return on assets ratio, therefore, indicates the efficiency with which your business uses its assets.

The higher the return, the more productive and efficient your business is in using its economic resources.

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 used to earn its profits indicates the likeliness of your company’s continued existence.

Return on assets is calculated by dividing your business’s net income by total assets.