How can you measure profitability in business? What makes a business profitable?
A return on investment statement measures how profitable an investment is compared to its cost, but many business owners may want to know how much their company is worth overall. To determine this, you look at three financial ratios: gross profit margin, operating profit margin, and net profit margin.
Keep reading to learn about these margins.
Measuring Profitability in Business
To measure profitability in business, Karen Berman and Joe Knight offer three financial ratios:
- Gross profit margin: Divide the gross profit number on the income statement by the total sales. This tells you how profitable your products and services are in and of themselves.
- Operating profit margin: First, subtract your operating costs from your gross profit, then divide by total sales. This percentage lets you gauge the profitability of your core business operations.
- Net profit margin: Divide the income statement’s net profit amount by your total sales—this lets you assess your overall profitability after all expenses.
Berman and Knight recommend that you track these ratios over time to spot trends in your company’s profitability. These margins show you how effectively your business generates profits at different stages of the money-making process. For instance, if your gross profit is high but your operating profit is low, then you may be paying too much overhead in day-to-day business operations. With these numbers, you can also compare your performance to business competitors and industry benchmarks.
| What Profit Margins Tell You As you track your company’s profit margins to measure the factors Berman and Knight describe, investors will likely be doing the same. For instance, financial analysts often use your gross profit margin to compare your business to industry competitors. A gross profit margin that doesn’t change much points to effective management and stable product performance, while swings up and down may indicate underlying issues that need attention. A low margin compared to your industry peers signals a need to reassess pricing strategies or find ways to cut production costs. Your operating profit margin speaks to how well you’re controlling variable costs that are largely under management’s discretion, such as employee wages and how much you spend on rental agreements. Unlike gross or net profit margins, your operating profit focuses on your core business operations, but a low operating profit margin doesn’t always signal poor performance, especially for growing businesses that reinvest heavily in expansion. Likewise, mature businesses in stable industries are expected to have higher operating margins. Context, therefore, is very important in judging the significance of operating profit. Of the three types of profit Berman and Knight list, your net profit margin provides the most comprehensive view of your financial condition. It shows how much of your business’s total revenue remains as profit after accounting for all expenses. A higher net profit margin indicates that you’re effectively managing costs and generating sales, but this metric alone doesn’t tell the whole story. It can be influenced by one-time events like shocks to the market or a merger with another business, so you shouldn’t rely solely on net profit to determine the strength of your business. |
