How to Measure Business Profitability
A company’s financial health is determined by several factors, one of which is the amount of profit it generates. This is why it is so important for business owners to understand their current, past and future profitability.
Here’s why profitability is so important, especially for small businesses, and how to effectively measure your profitability.
What is profitability?
Profitability is the ratio of a company’s income to its expenses. A company determines its income by calculating the money that the company makes from its operations and activities. A company determines its expenses by calculating the number of resources (money, time, and inventory) consumed in the course of its operations.
Executives can use this data to determine their company’s profitability using an income statement. An income statement is a report that details a company’s income and expenses during a specific accounting period.
To measure future profitability, a company can use a pro forma income statement that measures income and expenses for an upcoming accounting period. Some companies may create project income statements to determine the viability of a particular business change or upcoming business project.
[Read more: How to Calculate Small Business Profit]
Directors and owners should keep a close eye on their gross profit margin to ensure it remains stable over time.
Ways to measure profitability
Businesses can use a few different types of financial calculations to measure how profitable they are.
Gross Margin Ratio
A gross profit margin is an important piece of information as it analyzes a company’s cash 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 and then multiplying that number by 100.
Directors and owners should keep a close eye on their gross profit margin to ensure it remains stable over time. The ratio should fluctuate only when pricing policy or the price of goods changes.
Operating Profit Margin Ratio
An operating profit margin ratio illustrates a company’s earning potential from its ongoing operations. You can calculate your operating margin by dividing operating profit by net sales and 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 measure to calculate their competitive position within an industry.
Net Profit Margin Ratio
A net profit margin ratio calculates the amount of profit a company can make from its total revenue stream. To calculate, divide net income by net sales, then multiply that number by 100 to create a ratio.
Every industry has a different average net profit margin ratio, so business owners should compare their company’s net profit margin ratio to the industry average to assess annual performance. A net profit margin differs from an operating profit margin ratio because it takes into account earnings after tax.
Break-Even Analysis
A break-even analysis determines the point at which a company’s revenue equals its expenses. To calculate, a company must determine its fixed costs, variable costs and revenues. A variable expense is an expense that fluctuates based on sales. The break-even point is reached when sales equal fixed costs plus variable costs.
The break-even point can be expressed in either dollar amounts or units sold and is useful in determining how your business will respond when sales plummet. This method is incredibly valuable when planning a company’s future.
[Read more: How These Innovation Driven Startups Reached Profitability]
return on investment
A return on assets measurement shows the comparison between assets and turnover. The higher the number, the more efficient the business. To calculate your return on assets, divide your pre-tax net income by your 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 costs. If you end up spending more money than you make, it may not be worth the effort. To determine a company’s return on investment, divide its pre-tax net income by its net worth.
Regardless of what metrics you use to determine your overall profitability, it’s important to consistently track your company’s financial performance and health. The sooner you spot 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 unique situation.
To keep up to date with all the news impacting your small business, find all of our latest small business news and updates here.
CO— is committed to helping you start, run and grow your small business. Learn more about the benefits of small business membership in the US Chamber of Commerce here.
A message from
Get a free customized commercial for your business in minutes
Spectrum Reach Ad Portal creates a free 30-second commercial to promote your business on TV and streaming. Click here for your free commercial and to create your own advertising schedule!
Start here!
Published on October 14, 2022