Profitability combined with positive cash flow is key to your business’s long-term success and viability. Profitability is important to the concept of solvency and to that of a going concern.
How well is your business performing? Does its performance seem to be getting better or worse? Is your business making money? How profitable is your business compared with its competitors? These are all questions you can easily find the answers to by analyzing your profitability ratios. These ratios are used not only to evaluate the financial viability of your business; but are also essential in comparing your business to others in your industry and to identifying trends in your business by analyzing the ratios over a specific period. Profitability ratios enable you to examine how effectively your business transforms sales revenue into profits and can be broken down into three commonly applied ratios: gross profit margin, operating profit margin and net profit margin.
Gross Profit Margin:
Formula: Gross profit / Revenue
Gross profit measures how much sales income a business has left over after it covers the cost of goods sold (COGS). Gross profit margin indicates the gross profit as a percentage of revenue and is calculated by dividing gross profit by revenue. This percentage value indicates the proportion of revenue that is not consumed by the direct costs of producing the goods or services for sale. A higher gross profit margin indicates efficient processes and that a business is successfully producing profit over and above its’ costs. A lower gross profit margin may indicate that there are problems within the business, such as overpriced production inputs or under-priced products.
Operating Profit Margin:
Formula: Operating income / Revenue
Operating income takes gross profit and subtracts all overheads, administrative and operational expenses. Operating profit margin measures how much profit a business makes in sales, after paying for variable costs of production but before paying interest or tax i.e. earnings before interest and taxes (EBIT). It is calculated by dividing operating income by revenue. This is a more accurate indicator of a business’s performance than gross profit margin, since it accounts for not only the cost of sales but also the other important components of operating income, such as marketing and other overhead expenses. If your company shows a low operating profit margin (especially if your gross profit margin is healthy), it might be a sign that you are spending too much on operating costs. By analyzing this margin, you can better assess your ability to expand your business through additional debt or other investments.
Net Profit Margin:
Formula: Net income / Revenue
Net income is your business’s total profits after deducting all business expenses including interest and taxes. Net profit margin measures what percentage of a business’s sales is actual profit, after accounting for the cost of goods sold, operating costs and taxes. It reveals how much of the money your business earns makes its way to the bottom line. A high net profit margin typically indicates a company that is operating successfully and doing a good job managing costs and pricing its’ goods or services. A business with a higher profit margin than its competitor is usually more efficient, flexible and able to take on new opportunities.