While businesses are launched for various reasons – to fill a need gap in the market, capitalize on an opportunity, satisfy personal ambitions, and various others, the end result for sustained operations can be only one – profitability. Without profitability, long-term survival becomes a challenge.
In this scenario, measuring current and past profitability and forecasting this metric for the future is very important.
This brings one to the question: how do you analyze profitability? How can you constantly track revenues, ensure that the revenues exceed the expenses, and know whether the business will have enough funds to sustain itself in the future?
Financial ratios enable you to answer all the above questions. There are many ratios that provide information about the profitability of a business, but the following four are the most important and commonly used.
Preparing the balance sheet and income/expenditure statement is the crucial first step in calculating profitability, as all ratios are derived from data in the financial statements.
This is the basic profitability ratio that all companies have to calculate. Subtract the cost of goods sold from sales figures to get gross profit. Divide it by the sales figure and multiply it by 100 to get a percentage. This is the gross profit margin ratio for the business.
(Sales – Cost of Goods Sold) / Sales x 100 = Gross Profit Margin Ratio
This tells you if your company has sold enough goods and services to cover the cost of sales and still has capital left over. Needless to say, this number always has to be positive and also high enough to have a substantial impact on the business. If the costs are more and the sales are less, or the gross profit is not high enough, then you know that trouble is looming large.
Sale costs are not the only costs that the company is going to incur. You have to pay taxes on the profit as well. Is enough profit left over after taxes, depreciation, and other miscellaneous expenses have been paid? The net profit margin ratio gives an indication of this. If the company is paying high taxes and has to set aside funds for interest payments and depreciation, then it might not have much left by way of profit. In this respect, the calculation of the net profit ratio will enable the business to boost sales figures.
Look at numbers such as net income before interest, taxes, depreciation, and amortization, and net income after interest, taxes, depreciation, and amortization. Many companies display ratios, such as net income after taxes (NIAT) or net income after taxes and interest, on their balance sheet to identify how much expense has been incurred at each stage and how it impacts profitability.
Companies might make a profit in other ways, such as through the sale of assets or through their investments in non-core areas. However, it is important to calculate how much revenue the core business area generates and how much it costs to keep this core area functioning. Identifying the operating income, dividing it by sales, and calculating the percentage shows whether it was worth starting the business.
(Operating Income / Sales Revenue) x 100 = Operating Profit Margin
This number has to be consistently high to justify the existence of the company.
The ratios discussed so far are the basic ones that give information about the overall health of the company. You need to dig deeper to judge if the business is profitable enough. Break-even analysis reveals the sales needed to cover expenses. Calculating the per unit price will help in costing the products.
Return on assets(ROA)and return on investments(ROI) are other numbers that can reveal whether the business is optimally utilizing its resources.
However, these ratios should not be seen in isolation. Compare the profits with the industry standards on a year-on-year basis. The business has to make greater profits than its competition and also show a profit increase over time. Better utilization of resources could help to generate more profit.
Other ways to generate more revenue could be cutting costs to increase the margin, and saving taxes to increase the final earnings. However, the real value of these ratios and numbers lies in the lessons that you derive from them and the actions you take to improve profits.