If the revenue from your products and services is covering your expenses, you’re turning a profit. However, a profit dollar amount won’t tell you why you’re profitable. By calculating and comparing a handful of financial metrics, you can identify the areas of your business that are working well — and those that need improvement. Here are the four biggest ones to understand.
1. Net Profit Margin
Net profit margin, sometimes referred to as just “profit margin,” is the big picture view of your profitability. To calculate the margin, divide net profit — total revenue minus all expenses — by revenue. What’s considered a good margin is relative. 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.
Net profit margin tells if you’re profitable or not. However, it’s a 30,000-foot-view of your financial information. So you’ll need to keep crunching numbers to find out why the number is low or high.
2. Gross Profit Margin
If you sell physical products, gross profit margin allows you to home in on your product profitability. Your total gross profit is sales revenue minus your cost of goods sold. In other words, it’s profit after deducting direct materials, direct labor, and product overhead. But it doesn’t consider your general business expenses.
To calculate gross profit margin, divide gross profit by sales revenue. If gross profit margin is high, that means that you get to keep a lot of profit relative to the cost of your product. If it’s less than 50 percent, that means your product costs comprise more than half of your sales revenue. A low gross profit margin isn’t necessarily bad — it just means you need to sell enough product to be able to cover your general expenses. However, if you’re selling the same products and your gross profit margin is decreasing year-over-year, you need to find a way to reduce direct product costs or raise product prices.
If your net profit margin is sinking but your gross profit margin is where it should be, that signals that the problem probably has to do with sales and general expenses rather than product cost.
3. Comparative Expense Analysis
If you suspect that some operating expenses are creeping up, it’s a good idea to 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, and looks like this. It’s a little more time-consuming than a basic ratio calculation, but it’s not too bad as long as you can export the data from your accounting software into a spreadsheet program or run it directly within the program.
After you plug in the numbers, scan your comparative analysis for the biggest percentage changes over time. If there’s a good reason for an increase in an expense, that’s fine. However, if you can’t say why an expense has increased or identify what benefit it creates, it’s worth additional scrutiny.
4. 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 costs 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.