Today’s business word of the day is “profitable.” According to the unabridged Merriam-Webster English Dictionary, the definition of profitable is, “affording profits: yielding advantageous returns or results.” Thesaurus.com provides some related words, including “beneficial,” “cost-effective,” and “fruitful.” Other relevant words include “gainful” and “money-making.” Antonyms include “fruitless” and “valueless.”
Most business owners understand profitability from a fundamental standpoint. If the revenue from sales covers your expenses, you’re turning a profit. Profits mean positive cash flow. Positive cash flow helps keep your business in operation. Profitableness tends to be one of the primary goals of business owners. They seek to have a profitable experience and capitalize on material gain.
However, business owners should look beyond a simple profit dollar amount. The basic dollar amount doesn’t indicate why the business is profitable. Analyzing key metrics can help business owners determine whether their company is healthy, and profitability is sustainable. By calculating and comparing metrics, owners can identify the areas of the business that are working well — and those that need improvement.
Broadly speaking, there are three primary ways to determine whether you’re a profitable business: margin or profitability ratios, break-even analyses, and return on asset assessments.
In this article, we’ll provide you with a breakdown of everything you need to know to run a financial profitability analysis. The financial ratios and figures that we’ve included will not only provide you with an accurate measure of profitability but help predict future profitability as well.
Margin or profitability ratios
Perhaps the best way to determine whether you run a profitable business is by running margin ratios, also referred to commonly as profitability ratios. To run these figures, you’ll first need to calculate three things from your income statement:
- Gross Profit = Net Sales – Cost of Goods Sold
- Operating Profit = Gross Profit – (Operating Costs, Including Selling and Administrative Expenses)
- Net Profit = (Operating Profit + Any Other Income) – (Additional Expenses) – (Taxes)
All three of these figures provide you with a way to express profit from a dollar perspective. We can take this a step further by turning these figures into ratios. Doing so is beneficial because it allows you to analyze your company more accurately. Ratios help you measure efficiency much better than straight dollar amounts.
For instance, in Q1, you may have a higher gross profit margin than in Q4, even though you earned more money (from a dollar amount perspective) in Q4. Additionally, ratios allow you to compare your company to others in your industry.
Just because a company earns more profit doesn’t mean it’s financially healthy. Margin ratios are a far better predictor of health and long-term growth than mere dollar figures.
Below, we’ll look at how you can turn things like gross and net profit into ratios so that you can better analyze your company’s financial health. One ratio is not better than the other. All three will help give you an accurate look at the inner-workings of your business.
Gross profit margin ratio
If you sell physical products, gross margin allows you to hone in on your product profitability. Your total gross profit is sales revenue minus your cost of goods sold. Cost of goods sold represents how much your company paid to sell products during a given period.
In other words, it’s profit after deducting direct materials, direct labor, inventory, and product overhead. It does not consider your general business expenses. The formula to calculate the gross profit margin ratio is:
Gross Profit Margin Ratio = (Gross Profit ÷ Sales) × 100
If the gross profit margin is high, it means that you get to keep a lot of profit relative to the cost of your product. One of the primary things you want to concern yourself with is the stability of this ratio.
Your gross margins shouldn’t fluctuate drastically from one period to the other. The only thing that should cause a severe fluctuation would be if the industry that you’re part of experiences a widespread change that directly impacts your pricing policies or cost of goods sold.
Operating profit margin ratio
The operating margin provides you with a good look at your current earning power. Unlike gross profit, which you would prefer to be stable, an increase in the operating profit margin illustrates a healthy company. The formula to calculate the operating margin is:
Operating Profit Margin Ratio = (Operating Income ÷ Sales) × 100
The operating margin gives you a good look at how efficient you are. If you’re looking to compare your returns to others in the industry, this is the best ratio to do so, as it shows your ability to turn sales into pre-tax profits. Many individuals in corporate finance find this to be a much more objective evaluation tool than the net profit margin ratio.
One of the things that can keep this ratio stagnant is an increase in operating expenses. If you suspect that some operating costs are creeping up, you should perform a comparative analysis of your operating expenses.
A comparative analysis is a side-by-side percentage comparison of two or more years of data. It’s a little more time-consuming than a basic ratio calculation, but it’s not too bad if you can export the data from your accounting software.
After you plug in the numbers, scan your comparative analysis for the biggest percentage changes over time. Doing so will allow you to identify the reason for the expense increase and determine if it’s worth being concerned about.
Net profit margin ratio
Net profit margin, sometimes referred to as just “profit margin,” is the big-picture view of your profitability. Some industries — like financial services, pharmaceuticals, medical, and real estate — have sky-high profit margins, while others are more conservative. Use industry standards as a benchmark, and perform an internal year-over-year comparison to assess your performance. The formula to calculate the net profit margin ratio is:
Net Profit Margin Ratio = (Net Income ÷ Sales) × 100
Net profit margin is similar to operating profit margin, except it accounts for earnings after taxes. It demonstrates how much profit you can extract from your total sales.
Your break-even point is the point at which expenses and revenues are the same. You’re not making money at your break-even point, but you’re not losing money either. You should take time to measure your break-even point to determine how much “breathing room” you have in case things turn south.
As a business owner, you need to plan for the unexpected. Perhaps you lose access to raw materials because of a natural disaster. Or one of your manufacturers suffers a warehouse fire and can no longer provide you with the goods you need. Whatever the case, knowing the break-even point will let you know how much you can afford to lose before you are no longer a profitable company.
You can calculate the break-even point for various components of the business. For instance, you can measure the break-even point as a figure of sales. The formula to do so is:
Break-Even Point Sales = Fixed Expenses + Variable Expenses
You could also measure your break-even point against units sold. The method to do so is:
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 were something to happen to your company.
Return on assets and return on investments
The last two measures of profitability that you can get from your financial statements are return on assets (ROA) and return on investments (ROI). ROA shows total revenue compared to total assets used. You can use this figure as a comparison tool from period to period within your company and with other firms in your industry. The higher the ROA, the more efficiently you operate. The formula to calculate ROA is:
Return on Assets = (Net Income Before Taxes ÷ Total Assets) × 100
ROI shows how much you’re earning compared to the investments that you make. Measuring profitable investments allow you to ensure that you’re putting your money in the right places.
You want to make sure that your ROI is at least as high as what you’d be earning in a risk-free investment, like a high-yield savings account or CD. If it’s not, you’d be better off putting your money into one of these accounts, as they would yield higher earnings. ROI is basically a measure of whether “this is all worth it.” The formula to calculate ROI is:
Return on Investment = Net Profit Before Tax ÷ Net Worth
Also consider profit by segment
A lot of small businesses are subject to the 80/20 rule: Eighty percent of revenue comes from 20 percent of customers. Segment your business by product or service lines to find out which areas of your business have the best revenue and net income.
There are two ways to calculate profit by segment. One option is to identify the specific revenue and costs associated with the segment. If you do this, you’ll ignore overhead expenses like business insurance, rent, utilities, and executive salaries.
Alternatively, you can use a cost allocation plan to allocate overhead costs to each segment or service line. For example, if your salary comprises a big chunk of overhead, you would allocate that salary based on how much time you spend on each segment.
Evaluate your business needs
The evaluation of your bottom line should go beyond merely looking at your bank account. 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 software, owners can gain an insightful look at their company’s profitability. Doing so can put them in a position to achieve and maintain long-term success. Using the ratios that we provided in this article is an excellent way to get started.