Determining whether or not your business is profitable is an exercise you should conduct frequently. It’s not only important for you to understand the financial health of your business, but this information may come in handy when you’re looking for investors or want to take out a loan. After all, companies with high profit margins are considered a much safer bet among lenders and creditors than those with lower profit margins.
But in order to demonstrate profitability, you’ll have to do a bit of math. Don’t worry — it’s nothing too complicated. If you want to know how your company is doing financially, one of the best things you can do is to keep tabs on your profit margin by regularly running a profit margin analysis. Here, we’ll explain just what goes into calculating your profit margin, and how you can use the results to guide your business decisions for a prosperous future.
What is a profit-margin analysis?
As an entrepreneur, you’ve likely heard of a profit-margin analysis. But unless you were a business or accounting major during your time in college, the details about just what goes into the calculation may still be a bit fuzzy. There are three variables that you’ll need at your fingertips before you can begin. These are sales revenue, cost of goods sold, and profit.
1. Sales revenue
Although you’re likely already familiar with this one, a quick review never hurt. In short, your revenue is how much money your company earns through the sale of its product or service during a specified time period.
As an example, let’s look at a specific business — Tex’s T-Shirts. In this case, our small business owner, Tex, will want to be familiar with two types of revenue before he dives into his profit margin analysis: gross sales revenue and net sales revenue.
Gross sales revenue
First is gross revenue or total revenue. This is essentially just the sum of all sales receipts. So, if Tex sells 2,000 shirts for $15 each from January to March, his gross sales for the first quarter of the year will be $30,000.
Net sales revenue
Next, Tex will also want to know his net sales revenue. This will help him analyze his company’s performance and will usually be the revenue number he reports on his income statement. Net sales is equal to Tex’s gross revenue minus any product returns, damaged or missing products, and discounts or rebates.
For the sake of simplicity, let’s say that $10,000 of Tex’s T-shirts were returned or damaged. In this case, Tex’s net sales revenue would then be $20,000 ($30,000 – $10,000).
2. Cost of goods sold (COGS)
The cost of goods sold is an important factor when it comes time to calculate your profit margin. The cost of goods sold, or COGS, is the direct cost a company pays to produce its product or service, including materials and direct labor.
In Tex’s case, this would include the material used to make his T-shirts, the wages paid to the laborers who sewed them, and the electricity and rent on the factory where they were made. For each shirt he sold, Tex paid about $2 to create it, which would bring his cost of goods sold figure to $4,000.
This is also probably a familiar term, but just so everyone is on the same page: A profit is the revenue a company earns above and beyond its COGS. Again, while the concept seems pretty simple, it’s also worth noting that there are two different types of profit that will be relevant to Tex’s profit margin analysis. These include gross profit and net profit.
This is the number on a company’s income statement that reports the total revenue a business has earned minus the cost of the products or services sold for a given period. This is the business’s leftover cash before taking operating expenses into account. To calculate gross profit, you can use this formula:
Gross profit = net sales revenue – cost of goods sold
For Tex, we know that his net sales revenue for the first quarter was $20,000 but the cost of producing his T-shirts was $4,000. In this case, his company’s gross profit was $16,000 ($20,000 – $4,000).
In accounting lingo, this is also known as net income or net earnings. Because it’s usually found on the last line of a company’s income statement, it is often also referred to as the bottom line. To determine your net profit, you deduct your company’s operating expenses from the total revenue earned. The equation looks like this:
Net profit = gross revenue – (COGS + returns and exchanges + operating expenses + taxes)
Returning to Tex’s T-shirt shop, we know that his gross or total revenue for the first quarter of the year was $30,000. Among the expenses we’ll need to subtract from that gross revenue are the cost of goods sold ($4,000), and any expenses in the form of returns or damages ($10,000). This brings his total expenses thus far to $14,000.
However, we also need to factor in his taxes and operating expenses. In the first quarter, he pays $6,000 in taxes. He also pays one retail employee $1,000 each month to work at his store. To rent the retail space, he pays another $2,000 in rent each month, with an additional $333 utility bill. If we multiply each of those numbers by three for the first quarter, we find:
|Returns and exchanges:||$10,000|
|Total operating expenses:||$10,000|
|TOTAL Q1 EXPENSES||$28,000|
If we do a quick bit of math, we find that Tex’s net profit after subtracting all of his expenses was actually $2,000 ($30,000 – $28,000).
Profit margin ratio
While every company wants to achieve a profit for being in business, stating a simple dollar amount is not always that useful when determining how successful your business is. That’s where the profit margin ratio comes in.
A profit margin ratio expresses what percentage of a company’s sales are left after all expenses are paid. This is the overall profitability of a company. It is most often used by creditors and investors to determine how effectively a company converts its sales to income, and in many ways, it’s the easiest way to determine if a company is operating efficiently.
Just as with profits, there are also different types of these financial ratios that we’ll want to explore, including the gross profit margin ratio and net profit margin ratio
1. Gross profit margin ratio
A gross profit margin measures the amount of profit a company makes based on the cost of goods that are sold. While your company’s gross profit is expressed in dollar terms, your gross profit margin ratio is similar but expressed in percentage terms. The formula for determining your gross profit margin ratio is:
Gross profit margin ratio = (net sales revenue – COGS) ÷ net sales revenue
Revisiting Tex’s store, we know his net sales revenue is $20,000, and his COGS was $4,000. In his case, the gross profit margin would be 80%.
Gross profit margin ratio = ($20,000 – $4,000) ÷ $20,000
Accountants use this type of profit margin to gauge whether a company is employing effective pricing strategies. For instance, if you have a low gross profit margin, you might want to adjust the pricing of your good or service upward. With an 80% gross profit margin, it seems that Tex has picked a great selling price for his T-shirts.
2. Net profit margin ratio
Next, we have your net profit margin ratio, which is the profit generated from all phases of the business minus expenses. It’s calculated using the following equation:
Net profit margin ratio = (revenue – COGS – operating and other expenses – interest – taxes) ÷ gross revenue
Now, because revenue minus the cost of doing business is actually known as your net profit, you can also express this equation more simply with the following:
Net profit margin ratio = net profit ÷ gross revenue
In Tex’s case, when we divide his net profit ($2,000) by his gross revenue ($30,000), we find that his net profit margin ratio will be about 6.7%.
If your company’s net profit margin is high, that suggests you’re on the right track and your business is growing. On the other hand, if you have a low net profit margin, that’s usually an indicator that there may be poor management decisions, a weak demand for your company’s products and services, or high costs, which ultimately results in weak sales and low revenue.
Considering the average net profit margin ratio in the retail industry hovers around 1.9%, we can conclude that Tex’s T-shirt business is doing great.
How to use profit-margin analysis
As you can see, running these types of profitability ratios can give you some great insights into the health of your business. If you find that your overall profit margin is less than ideal, it might be worth running each of the above calculations to see if a certain area is proving to be a challenge. It’s possible that your organization excels at managing its raw materials and resources to manufacture goods, but is challenged by rising expenses or other fixed costs.
The best way to determine if your profit margin is “normal” for your type of business is to compare it to other organizations in your industry and of a similar size. Additionally, consistently high profit margins may indicate that an organization can survive an economic downturn or other financial setback and still remain in business. This is further evidence that the company is a low-risk investment for lenders and investors.
It’s best to know your company’s financial health before you seek investors or look for ways to increase revenue or lower expenses. By having a good handle on these different profit margins you’ll be able to make smart, forward-thinking decisions when it comes to your business’s bottom line.