Calculating your businesses financial performance and utilizing the information to make decisions plays a critical role in driving your growth and increasing profitability. That being said, with so many different metrics pertaining to various parts of your business, it can feel overwhelming.
Today, we’re going to discuss the basics about profitability ratios, why they are necessary, and the ones you should focus on.
What Are Profitability Ratios?
Profitability ratios are a collection of financial metrics that are used to assess a business’s ability to generate earnings relative to its revenue, operating costs, balance sheet assets, or shareholders’ equity over time, using data from a specific point in time.
Simply, they measure your company’s ability to earn a profit.
And if you have shareholders, profitability ratios will show how well you use existing assets to generate profit and value for them, too.
What Do Profitability Ratios Tell You?
In most ratios, having a higher value relative to a competitor’s ratio or relative to the same ratio from a previous period signals successful performance. Profitability ratios are most useful when compared to similar companies, the company’s own history, or average ratios for the company’s industry.
The 3 margin ratios that are crucial to your business are gross profit margin, operating profit margin, and net profit margin.
RATIO #1: GROSS PROFIT MARGIN
The most widely used margin ratio, gross profit margin, calculates the amount left over after covering the cost of goods sold. You will find the numbers needed to calculate this ratio on your business’ income statement.
A high gross profit margin reflects a high efficiency of earning revenue and covering business expenses, taxes, and depreciation.
gross profit margin = (total sales – cost of goods sold) ÷ total sales
RATIO #2: OPERATING PROFIT MARGIN
The operating profit margin, also known as earnings before interest and taxes (EBIT), takes earnings as a percentage of sales before deducting interest and taxes. It is calculated by taking your gross profit and subtracting operating costs—these expenses usually include rent, utilities, salaries, administrative and general costs.
Your operating profit margin is a valuable tool to determine how well your business can adapt during slower periods. It can also determine profitability for seasonal businesses—when profits may decrease, but you may still need to cover operating expenses.
operating profit margin = operating profit ÷ revenue
RATIO #3: NET PROFIT MARGIN
Net profit margin shows how much your business generates in profit once you have paid all expenses.
A high net profit margin is not only an indication that your company is successfully operating, it means that you’re excelling at managing costs and pricing your goods or services to generate income.
Again, your income statement will provide the figures needed for this formula:
net profit margin = net income ÷ revenue
The 2 return ratios that are crucial to your business are return on assets and return on equity. These determine how much profit you are generating for owners and/or shareholders.
RATIO #4: RETURN ON ASSETS
Return on assets (ROA) focuses on the efficiency of using assets to generate profitability. This is valuable information as it informs the business how well it uses its resources and assets to generate a profit.
Here is a simple formula for return on assets:
return on assets = net income ÷ total assets
RATIO #5: RETURN ON EQUITY
Return on equity is a critical ratio for shareholders and investors in the business. It measures the return on investment that investors have put into the company, which can be useful when trying to gain new investors. Again, the figures needed for this formula come from the income statement.
return on equity = net income ÷ average shareholder’s equity
How You Can Use Profitability Ratios in Your Business
As you intensely monitor your company’s bottom line, you want to ensure the efficiency of all business operations to increase profitability. By measuring current and past profitability, you can properly project future growth.
Always remember that when evaluating your profit ratios, compare them to competitors in your industry to get a clear picture of where you stand.
Following are three important reasons to calculate and track your profitability ratios.
Evaluate Performance Over Time
Analyzing profitability ratios annual or quarterly brings visibility into how your business is performing. Comparing these ratios over a period of time helps inform future strategies and can also be used to explain years where financial performance was poor. This is especially important as businesses continue to bounce back from the COVID-19 pandemic.
Being able to measure these effects is crucial for assessing a company’s financial health and evidence of post-pandemic growth.
Identify Weak Business Areas
Numbers themselves don’t tell a story, but data with a story does. Tying your income statement and balance sheet into meaningful ratios helps uncover areas of your business that are excelling and needing improvement.
The following steps could further evaluate the different administrative costs to see where the operating ratio can be lowered.
By providing exclusive insights into the performance of your company, evaluating your financial ratios should be one of your most top priorities.
Unfortunately, however, accounting errors, absence of information and lack of knowledge can cloud a company’s judgement, thus resulting in decision-driven mistakes.
To avoid making mistakes affecting your bottom line, seek the financial guidance of one of our objective and qualified accounting professionals. Where we are different from other financial advisors is in our ability to properly use your financial insights to guide you on your best path — cutting costs, preventing mistakes, driving performance and increasing your profitability.
See how one of our trusted financial advisors can help you and put your mind at ease with the end of the year just around the corner. Call our office headquarters in Placentia, Orange County, California today to speak with one of our experts in a free, no obligation discussion!
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