Key Profitability Ratios to Keep and Eye On

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Profitability ratios provide useful and usable information to small business owners. These ratios can give you a large amount of information about the health of your business.

A lot of small business owners tend to shy away from looking at profitability ratios because they can be a little confusing, so here is a quick guide to teach you a little bit about what profitability ratios are and why they important.

Why Are Profitability Ratios Valuable Information?

Before we look at each type of profitability ratio, it’s important to understand why they are even important ratios to know about. A common misconception by many business owners is that these ratios only come into play when they are ready to look for investors or if their business has shareholders. While profitability ratios are in fact used for these purposes, they are also valuable to business owners who aren’t necessarily looking for investors.

Examining profitability ratios and comparing them with industry key performance indicators can show you whether your million dollar company is actually profitable; Or if you’ve been spending too much money and you’re not as profitable as you actually thought.

What Are Profitability Ratios?

Profitability ratios are a class of financial metrics that are used to assess a business’s ability to generate earnings compared to its expenses and other relevant costs incurred during a specific period of time.

Profitability ratios are a class of financial measures that are used to assess a business’s ability to generate earnings, as compared to its expense and other relevant costs incurred. They are simple calculations that turn the numbers from your financial statements into percentages. The three most common and valuable profitability ratios that are useful and valuable to small business owners are:

  • Gross profit margin
  • Operating margin
  • Net profit margin, or just profit margin

Each of these profitability ratios tells you something a little different about your business.

GROSS PROFIT MARGIN

The gross profit margin ratio shows you the percentage of your income which is actually yours to use for business operations. The equation to calculate this ratio is as follows:

((Total Sales Revenue – Total Cost of Goods Sold) / Total Sales Revenue) x 100 = Gross Profit Margin

This is a quick and easy way to tell you what percentage of every dollar that comes in to your business as revenue can be used for something other than covering the cost to make the goods you’re selling. Multiplying by 100 converts the decimal to a percentage, and now you have your gross profit margin.

It is highly recommended that you analyze your gross profit margin for each of your products or services so you know which sources of revenue to focus on for growth, and which products or services are bleeding you of your revenues.

Example:

Your business generates $200,000 in income

Your Profit Margin is 50%.

That means 50% of your income goes to producing the actual goods and services you’re selling, and 50% (or $100,000) is left over for running your business, paying your employees, covering fixed costs, and any expansion costs you have coming up.

OPERATING MARGIN

Operating margin tells you what percentage of your income is left over after factoring in operating expenses. One way to look at operating margin is to think about the gross profit margin we discussed above, and then find the same ratio, only this time we are factoring in all operating expenses as well. An operating expense is any expense that a business incurs to engage in any activities not directly associated with the production of goods or services. Essentially, these are the costs of running a business: rent, payroll, office supplies, accounting fees, etc. (This does not include taxes or other non-operating expenses.)

The simple equation is similar to gross profit margin and is as follows:

((Total Sales Revenue – Total Cost of Goods Sold – Total Operating Expenses) / Total Sales Revenue) x 100 = Operating Margin

The operating margin tells you what percentage of your income is left over (after paying your production costs and operating costs) before paying taxes and other non-operating expenses.

Example

Your business generates $200,000 in income

Your operating margin is 30%

That means that 70% of your income goes towards producing the actual goods and services you’re selling, and towards your operating expenses ( such as paying employees, paying rent, etc.) You have 30% (or $60,000) left over to pay for things like taxes and non-operating expenses.

NET PROFIT MARGIN

Your net profit margin (usually to as profit margin) is a lot like the other two margins and it tells you what percentage of income your business keeps after paying ALL expenses. This includes production costs, operating expenses, taxes, financing costs, etc.

The equation even more simple than the other two:

(Net Profit / Total Sales Revenue) x 100 = Profit Margin

You can find your net profit figure from your profit and loss statement (sometimes labeled net income), or you can add up all of your production costs, operating costs, taxes, financing costs, etc. to find this number as well.

The net profit margin tells you how much money you have left over after all expenses are paid. This is considered retained earnings, or profit.

Example

Your business generates $200,000 in income

Your net profit margin is 10%

That means that 90% of your income goes towards producing the actual goods and services you’re selling, and towards your operating expenses, ( such as paying employees, paying rent, etc.), and towards paying all other expenses (taxes, finance expenses, etc.). You have 10% (or $20,000) left over for profit or retained earnings.

Simply looking at your “total income” and “net income” can be misleading. If you appear to have a large net income, you must take into consideration what and how much it took to get there. This is why looking at these ratios is important; they tell you what percentage of your income is spent on what, and how much is left over when it’s all said and done. This is why it is important to know these figures and not to simply look at large income numbers which aren’t telling you the whole story.

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