Of the five types of financial ratios, profitability ratios provide the most useful and usable information to small business owners. With just a quick glance, these ratios can give you an immense amount of information about the health of your business.
Unfortunately, there is a lot of technical speak surrounding profitability ratios, which causes many small business owners to shy away from them.
Let’s change that now.
Before we look at each profitability ratio, it’s important to understand exactly why they are valuable to small business owners. Many business owners think these ratios only come into play when they are ready to find investors or if their business has shareholders. While profitability ratios are used extensively for these purposes, they are also valuable to business owners who have no interest in expanding their business to that point.
Every industry has key performance indicators (or KPIs), which serve as a yardstick for determining industry standards and how one business in an industry compares with another. Looking at dollar amounts alone is insufficient. A $1 million business sounds extremely successful, but it’s not uncommon to run some quick profitability ratios and discover a $100,000 business in the same industry is actually more profitable.
By leveraging the equalizing power of percentages, profitability ratios let small business owners effectively compare apples to apples. A small business owner might be disheartened by his business’s “small” scale, but once he analyzes his profitability and compares it with the KPIs for his industry, he might learn his business is actually a top performer.
Likewise, examining profitability ratios and comparing them with industry KPIs can serve as a wakeup call to the small business owner whose “you have to spend money to make money” mindset is pushing her business toward insolvency.
Profitability ratios are simple calculations that break down the numbers from your financial statements into percentages. The three profitability ratios that are most valuable to small business owners are:
Each of these profitability ratios tells you something different about your business.
This ratio tells you how what percentage of your income is actually yours to use to operate your business. The equation looks like this:
((Total Sales – Cost of Goods Sold or Production Costs) / Total Sales) x 100 = Gross Profit Margin
This is actually less complicated than it seems. Take the gross profit number from your profit and loss statement, and divide that by your total income number. Multiply the result by 100 (to convert the decimal to a percentage), and you have your gross profit margin.
What this tells you: Your gross profit margin shows you at a glance if your prices are too low or if your costs are too high. You can—and should—analyze your gross profit margin for each of your products or services so you know which revenue streams to focus on for growth and which to cut loose because they are dragging down your business’ profitability.
Another way to look at gross profit margin: If your business generates $100,000 in income and your gross profit margin is 60%, that means 40% of your income goes to producing the income itself and 60% is left over for running your business.
The operating margin tells you what percentage of your income is left over after factoring in operating expenses. An operating expense is any expense incurred in the normal course of business—rent, payroll, office supplies, accounting fees, etc. It does not include taxes or other non-operating expenses.
The equation is similar to gross profit margin:
((Total Sales – Cost of Goods Sold – Operating Expenses) / Total Sales) x 100 = Operating Margin
Again, this can be simplified by dividing the net operating income number from your profit and loss statement, dividing it by your total income number, and then multiplying by 100.
What this tells you: Your operating margin tells you what percentage of your income is left over before paying taxes and other non-operating expenses.
In other words, if your operating margin is 10%, it means 90% of your business income is used to either pay for sales or production costs or to keep the business itself running.
Your net profit margin (usually just profit margin) tells you what percentage of income your business keeps after paying all expenses—operating expenses, taxes, financing costs, etc. Note that expenses do not include asset acquisition, owner draws, or other cash outputs that appear on the balance sheet.
The equation is simple:
(Net Profit / Total Sales) x 100 = Profit Margin
From your profit and loss statement, take the net profit (or net income) number at the very bottom of the statement, divide that by your total income number, and multiply by 100.
What this tells you: Your profit margin tells you what percentage of your business’ income is “left over” for retained earnings or profit.
This means if your profit margin is 3%, then 97% of the money your business makes goes to pay for sales or production costs, to keep the business running, and to pay taxes and financing costs.
While you might be tempted to rejoice at your business’ profit and loss statement because total income and net income are both on the rise, you don’t want those dollar figures to become “vanity numbers.” Depending exclusively on the change in these numbers causes small business owners to miss vital information about the health of the business.
Look at it this way: Profitability ratios provide a quick and clear way to analyze your business’ P&L objectively—information you can use to either compare your business’ performance with similar businesses in your industry or to objectively analyze your company’s financial position across multiple time periods.