There are many different ways to assess the financial performance of your business, however profitability is the most obvious indicator of how well your company is doing. In its most basic definition, “profitability” refers to the extent to which a company is making a financial gain. So, in order to make a profit, the company’s output needs to be higher than the cost of its inputs. Profitability is key to allowing a business to grow or thrive by ensuring it can:
- Meet all financial obligations, namely paying any liabilities that are owed
- Operate efficiently
- Reward owners and employees
- Encourage economic opportunities, such as investment
So we know that profitability is essential to the health and welfare of a business, but how can you measure profitability in your company? There are 4 main ways to measure profitability. Let’s take a look at what these are.
How To Measure Profitability
Break-Even Analysis
If a business is “‘breaking-even” this means that their expenses are equal to that of their revenues. This means that they are not making a profit, however they are also not making a loss. Once your company reaches a break-even point it creates a plateau from which the business can start to become profitable i.e increase its revenue. In order to measure profitability in this way you need to be aware of where your break-even point is. This will allow you to notice when your business is making a profit or a loss. This allows you to measure profitability by determining the relationship between your revenue, product costs or sales volume.
Gross Profit Margin Ratio
Gross profit refers to the profit that’s left after the cost of goods sold is subtracted from net sales. (“Cost of goods sold” referring to the price your business pays for the products it sells). Gross profit margin is an important way to measure profitability as a good gross margin indicates that your company can pay for its operating costs and other expenses. The formula for calculating gross profit margin is:
(Net Sales – COGS)/Net Sales
Net Profit Margin Ratio
Another way to measure profitability is to determine the net profit margin ratio. Net profit refers to the actual profit that your company makes after working expenses not included in the calculation of gross profit have been paid. This is an important method for measuring profitability as it tells you how much your company earns in revenue. The formula for this is as follows:
Net Profit Margin = [(Revenue – COGS – Operating and Other Expenses – Interest – Taxes)/ Total Revenue] x 100
Operating Profit Margin Ratio
The final method for how to measure profitability is working out the operating profit margin. This indicates how much money a business makes once operating costs such as production and wages have been deducted. A higher ratio shows that a company is efficient in its operations. The ratio is calculated using the following formula:
Operating Profit Margin = Operating Earnings/Revenue
In order to maintain profitability and ensure that your business stays healthy it’s essential to ensure you continue to measure profitability and keep accurate records of your company’s finances. If you do notice signs of financial trouble, you should consult professional guidance as early on as possible. The earlier you do this, the more options there will be for recovering your business.
If you’re concerned about the welfare of your company, please don’t hesitate to get in touch with the team at Ballard Business Recovery for tailored advice.
