A business’s financial health is determined by various factors, one of which being the amount of profit generated. That’s why it’s so important for business owners to understand their current, past, and future profitability.
Here’s why profitability matters so much, especially for small businesses, and how you can effectively measure yours.
What is profitability?
Profitability is the ratio between a business’s income and its expenses. A business determines its income by calculating the money the business generates through its operations and activities. A business determines its expenses by calculating the number of resources (money, time, and inventory) consumed during the course of its operations.
Leaders can use this data to determine their business’s profitability through an income statement. An income statement is a report detailing a business’s income and expenses during a particular accounting period.
To measure future profitability, a business may use a pro forma income statement, which measures income and expenses for an upcoming accounting period. Some businesses may generate project income statements to determine the profitability of a particular business change or upcoming business project.
[Read more: How to Calculate Small Business Profit]
Business managers and owners should keep a close eye on their gross profit margin ratio to ensure it stays stable over time.
Ways to measure profitability
Businesses can measure how profitable they are with a few different types of financial calculations.
Gross profit margin ratio
A gross profit margin ratio is vital information as it analyzes a business’s money flow. To first calculate your gross profit, subtract the cost of goods sold (COGS) from net sales. Next, calculate the gross profit margin ratio by dividing your gross profit by net sales, then multiplying that number by 100.
Business managers and owners should keep a close eye on their gross profit margin ratio to ensure it stays stable over time. The ratio should only fluctuate when pricing policies or the price of goods changes.
Operating profit margin ratio
An operating profit margin ratio illustrates a business’s earning potential from its current operations. You can calculate your operating profit margin ratio by dividing operating income by net sales, then multiplying that number by 100.
A healthy operating profit margin ratio is one that increases from one accounting period to the next. Businesses use this profitability measurement to calculate their competitive position within an industry.
Net profit margin ratio
A net profit margin ratio calculates the amount of profit a business can extract from its total revenue stream. To calculate, divide net income by net sales, then multiply that number by 100 to create a ratio.
Each industry has a different average net profit margin ratio, so business owners should compare their business’s net profit margin ratio to the industry average to assess yearly performance. A net profit margin is different from an operating profit margin ratio because it accounts for earnings after taxes.
A break-even analysis involves determining the point at which a business’s revenues equal expenses. To calculate, a business will need to determine its fixed expenses, variable expenses, and sales. A variable expense is an expense that fluctuates based on sales numbers. The break-even point is when sales equal fixed expenses plus variable expenses.
The break-even point can be expressed in either dollar amounts or units sold and is useful in determining how your business will react when sales slump. This method is incredibly valuable when planning for a business’s future.
[Read more: How These Innovation Driven Startups Reached Profitability]
Return on assets
A return on assets measurement demonstrates the comparison between assets and revenue. The higher the number, the more efficient the business. To calculate your return on assets, divide net income before taxes by total assets, then multiply that number by 100.
Return on investment
Return on investment allows a business owner to determine if the financial benefit of a project or investment is worth the initial and ongoing expenses. If you will ultimately spend more money than you’ll earn, the venture may not be worth it. To determine a business’s return on investment, divide net profit before taxes by net worth.
No matter which metrics you use to determine your overall profitability, it’s essential to be consistent about tracking your business’s financial performance and health. The sooner you can identify potential problems and negative trends, the sooner you can take action to get back on track.
CO— aims to bring you inspiration from leading respected experts. However, before making any business decision, you should consult a professional who can advise you based on your individual situation.
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Published October 14, 2022