Measuring profitability in a business is essential to understanding how well it’s running. From measuring minor operational changes to exiting via sale, understanding what your business’s bottom line truly means is the only way to accurately determine its value. If you run a business, here’s an overview of how to measure profitability.
How To Measure Profitability
Knowing your business’s numbers is foundational to assessing profitability. Inaccurate figures will lead to inaccurate conclusions. Don’t go with what you think the business makes and spends, and don’t use what you expect future sales and expenses to be. Use hard data from the past months or years — yes, you need to keep accurate records — to gain a true understanding of your business.
There are multiple numbers that every business owner should know. Here are a few of the more important ones related to measuring profitability:
- Gross Revenues
- Net Income
- Cost of Goods Sold (COGS)
- Operating Expenses
- Other Income
An accountant can help you calculate these, so long as you have the necessary records. Because records are so important, it’s generally advisable to hire a bookkeeper or accountant as soon as you start a business (or now if you already have a business).
Measuring Profitability: Key Ratios
Your gross revenues show the top-line income that your business makes, and net income generally shows how much the business actually earns after expenses. These figures become even more important to measuring profitability when put in the context of profitability ratios, though.
There are multiple profitability ratios that show how much a business earns with respect to different underlying costs. Some of the most common ratios are:
- Gross Profit: Gross profit measures how profitable your goods/services are to sell. It puts the earnings in perspective to the cost of those goods, and the best way to improve this is to either raise prices or find lower-cost suppliers.
Formula: Gross Profit = Revenue – Cost of Goods Sold
- Operating Profit: Operating profit provides a more complete picture, as it takes into account the cost of goods sold plus how much it costs to run your business. This can be improved by bettering the gross profit or reducing operating expenses.
Formula: Operating Profit = Gross Profit – Operating Costs
- Pre-tax Profit: Pre-tax profit gives a complete view of your business’s profitability before the government gets its share via taxes, taking into account any other income and any non-operational expenses. The ratio will be improved by any positive change to sales, sourcing, operations, or almost any other aspect of your business.
Formula: Pre-tax Profit = Operating Profit – Non-Operating Expenses
- Net Profit: Net profit shows exactly how much money your business is making after everything is taken into account. Any change in revenues or expenses will impact this.
Formula: Net Profit = Pre-tax Profit – Taxes
These profitability ratios are even more informative when used to calculate other ratios that look at returns. Most people use net profit when showing how to calculate profitability ratios that are more advanced:
- Return on Investment: ROI is most useful when assessing whether a major investment in a business is financially advisable. You may use this when determining whether to purchase another business or when considering expanding operations. The ratio shows what sort of return you’ll receive from the outlay.
Formula: ROI = Net Profit / Initial Investment
- Return on Assets: ROA looks specifically at the tangible assets a business has to determine how well they’re deployed. You can use this when evaluating a major capital outlay or assessing the use of existing infrastructure/equipment. Unlike ROI, ROA will change more over time as the value of assets fluctuates with additional purchases and depreciation.
Formula: ROA = Net Profit / Assets’ Total Value
- Return on Equity: ROE is most often used to evaluate business profitability from a shareholder perspective. The ratio shows how much shareholders are earning. Improving profitability, rebuying equity, and issuing new equity will all impact this.
Formula: ROE = Net Profit / Equity Investments
Each of these three ratios can be multiplied by 100 for a percentage.
For more tips on measuring profitability check out The Ultimate Small Business Profitability Checklist. It provides five key metrics you should know and be watching to understand your profitability.
Download a free copy here and get started measuring profitability in your business.
Work With a Knowledgeable Accountant
Evaluating profitability can be challenging even when you know how to calculate it via these various ratios. Working with a knowledgeable accountant who knows how to measure profitability will give you the confidence necessary to make informed business decisions. Book a free consultation if you’d like assistance determining how profitable your business is and where profits might be improved.
Avisar Chartered Professional Accountant’s blog deals with a number of complex issues in a concise manner; it is recommended that accounting, legal or other appropriate professional advice should be sought before acting upon any of the information contained therein.
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