Profitability is usually one of the top concerns of business owners. Today we are bringing you a tool that you can use, relatively easily, on a regular basis to keep better tabs on the profitability in your business and ways to benchmark against not only yourself but others in your industry! In the last episode, we scratched the surface of liquidity ratios and the importance of reviewing your business data. We are going to take this topic a step further and cover another ratio because your numbers provide tremendous insight on your business’ performance. This time we are talking about profitability ratios. As a business owner, profitability is critical so we are concentrating on the importance of profitability ratios, goals for your profit margins, and practical measures you can take to increase your profitability ratios.
What we cover in this episode:
- 01:16 – Profitability ratios defined
- 05:02 – Profit margins
- 05:10 – Gross profit
- 06:30 – Net profit
- 11:17 – Return ratios
- 14:03 – Improve profitability ratios
Profitability ratios defined
Profitability ratios are financial measures to analyze the ability to earn a profit. These ratios can be used to assess a business’s ability to generate earnings relative to various things like revenue, operating costs, balance sheet assets, shareholders’, and more. Today, the two main profitability ratios we’re going to dive into are margins and returns.
Comparing profitability ratios to gain insight
Understanding your profitability ratios, like liquidity ratios, helps you check the pulse of your business. This data, like liquidity ratios, lets you know where you stand in relation to other businesses and displays that data with trends. This information plays into the bigger picture and gives you an overarching sense of how your business is functioning. The profitability ratio calculates a percentage, which you can use to compare your business with others in the industry, regardless if your business is the same size. Comparing percentages levels the playing field with other larger or smaller businesses. Your profitability ratio may reveal you are just as profitable as other larger companies. Comparing profit amounts simply by looking at dollars and cents does not give you the same insight.
Comparing profitability ratios to trends from the past and previously established goals helps you uncover areas where you need to shift your focus and attention. Additionally, having solid profitability ratios can help attract new investors. When your business has a healthy profitability, investors are more likely to be interested. Generally, for profitability ratios, the higher the ratio, the better. This makes sense when you look at your profit and loss statement; the higher the net income or profit, the better.
There are two types of profit margins, gross profit margin and net profit margin.
To calculate the gross profit, subtract your cost of goods sold, or cost of sales, from your net income.
EXAMPLE: Company Z had $2.5 million in annual sales and the cost of goods sold was $1.5 million. The gross profit for Company Z is $2.5M – $1.5M = $1M
Gross profit margins
The formula to calculate your gross profit margin is net income minus the cost of goods sold, or the cost of sales, divided by the total annual sales amount.
EXAMPLE: Company Z had gross profit of $1 million and $2.5M in annual sales. The gross profit margin calculation for Company Z is $1M / $2.5M = .40. This means the gross profit margin is 40%.
The gross profit margins are then used to compare with your prior year to determine if your percentage is improving and if you are meeting your established goals. For instance, if Company Z set their gross profit percentage goal at 50%, they would see they haven’t reached their goal. If that’s the case, they would then want to look further at the data to identify where they fell short. However, if Company Z set their gross profit percentage goal at 35%, they’d be in good shape. A general guideline for gross profit margin is 50 percent because you want to have enough revenue left to cover all the other important operating costs, like marketing, rent, staff payroll, etc. that are not included in your COGS. However, the goal of your gross profit will vary from business to business, so we recommend taking these types of generalities lightly and instead focus on concrete information.
To calculate the net profit, subtract all expenses (including depreciation, amortization, and taxes) from the gross profit.
EXAMPLE CONTINUED: Company Z had $750,000 in expenses and taxes. Gross profit, as calculated above, is $1 million. The net profit for Company Z is $1M – $750k = $250k
Net profit margin
The formula to calculate the net profit margin is gross profit minus the cost of expenses, divided by the cost of goods sold or cost of sales.
EXAMPLE CONTINUED: Company Z had a net profit of $250,000 and total annual sales of $2.5M. The net profit margin calculation for Company Z is $250,000 / $2.5M = .10. This means the net profit is 10%.
Like gross profit margins, your net profit margins should be compared to your goals and historic net profit data. The general guideline is that a net profit of 5 percent is considered low, 10 percent is average, and 20 percent or better is good. No matter what, look at your industry to see what is acceptable instead of relying on general rules. For our example with Company Z, since we don’t have industry-specific information, we would use common knowledge and determine that the company is performing about average because their net profit is 10 percent.
The gross profit margin and net profit margin should be reviewed often, maybe even month-to-month, quarter-to-quarter, and then year-to-year to know how your business is functioning, specifically in relation to its profitability. You want to know what kind of sales you are generating and begin to see trends as they relate to any changes you’ve made, operational improvements, etc.
There are two types of return ratios, return on assets and return on equity.
Return on assets
Return on assets, often referred to as ROI, tells you if the company is turning investments into profit efficiently. To calculate ROI, divide net income by total assets.
EXAMPLE CONTINUED: Company Z had total assets of $3.5 million. Net income, as calculated above, is $250,000. The ROI is $250K / $3.5M = .07, or 7%.
Company Z has an ROI of 7 percent and in general, an ROI of 5 percent or more is good. If the ROI was below 5 percent, you’d want to conduct research to determine the areas that need improvement.
Return on equity
Return on assets, often referred to as ROE, tells you how well the company can use shareholder investments to generate profits. ROE measures the shareholder’s return on investment. To calculate ROE, divide net income by average shareholder equity.
EXAMPLE CONTINUED: Company Z had $2,000 of average shareholder equity. Net income, as calculated above, is $250,000. The ROE is $250K / $2K = .125, or 12.5%.
Company Z has an ROE of 12.5 percent and, in general, an ROE of 15 percent or more is seen as a good return on equity. In this example, Company Z is a bit shy of 15 percent but they are headed in the right direction.
Compare your return ratios to historical company data, industry data, and your established goals to help you see if your assets and shareholder investments are turning into profits.
Improve profitability ratios
Once you calculate your profitability ratios, you may notice things aren’t where you need or want them to be. If this is the case, you’ll want to consider taking action.
Options to improve your profitability and your ratios:
- Look at your services or product lines to see if any are unprofitable. If so, remove those services or products. In turn, this could result in rapid improvement to your bottom line and profitability.
- Find more customers to increase sales, although sometimes this can be costly.
- Consider increasing your pricing. If you haven’t increased prices annually, you may be under-pricing your services or products.
- Review expenses and reduce them. Determine your highest expenses and see if it’s possible to decrease them. Some expenses, like salaries, can’t be reduced. Your employees are those helping you produce a good or service, and you need them. Other expenses can be reduced, even by a small amount. Find out if you can get volume discounts. Determine if you’re paying for things you don’t really need. A difference of 1 or 2 percent of the bottom line can make a big difference in profitability ratios.
If one of your main goals is to improve profitability, we recommend reviewing your profitability ratio on a monthly basis, at least. If profitability isn’t an area of concern, it doesn’t need as much time or attention but still should not be ignored. It’s more important to find areas that need work because they aren’t meeting your goals, and focus efforts there. It is a good idea to keep an eye on profitability ratios no matter what to ensure they are trending in the right direction. If you make changes in other areas, profitability can quickly turn around month-to-month, and you’ll want to notice this right away.
If you’re looking for help with getting a handle on your ratios, profitability and more, reach out for a free conversation and strategy session! We are happy to talk with you and discuss goals and learn more about your business. Book your session here.
Some of you may be wondering what you can do to obtain industry averages and other industry-specific information. There may be free resources online that give industry benchmarks, but some information may need to be obtained through a third-party service. You can pay companies like ADP to provide industry-specific reports. We suggest talking with your business advisor, virtual CFO, and networking with people in your industry to see if they have recommendations for where to seek information pertaining to your industry.
The power of numbers is real! If you take away one key piece of information from today’s episode, we hope it is KNOW YOUR DATA! Ok, maybe we need you to take away more than just that because knowing your data is important, but understanding it and knowing how to use it are also crucial. Today, we talked about ratios, specifically profitability ratios. There are two profitability ratios, profit margins and returns. These show you if your business is profitable. Every business owner has the goal of being profitable! There are two types of profit margins, gross profit margin and net profit margin. Your net profit margin is the bottom line because it is calculated without including expenses. There are also two types of returns, return on assets (ROI) and return on equity (ROE). These show if you are making money on investments, and if that money is being made effectively. Next, we shared with you some figures to help you loosely identify if your business is healthy or if you need to take action. As always, we recommend doing industry-specific research when comparing your data. What we share with you is just a guide and guidelines vary widely between industries. We talked about actions to consider if your data isn’t what you hoped. You may need to make changes in your business to increase your profitability so we provided a few options for consideration. Lastly, we talked about utilizing your resources wisely, tapping into your advisor, virtual CFO, and your network to determine the best place to obtain industry-specific information.