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Calculating Profitability Ratios


Profitability


Your gross profit margin and your net profit margin are the main figures you can use to track whether your profitability is improving. You therefore need to know how to use the information on your profit and loss statement to calculate these figures.
  • Gross Profit. This shows the difference between total sales and the cost of producing the goods or services you sell. It shows you how much money is available to cover your expenses. Basically, in order to make a profit, you need to ensure your gross profit is higher than your expenses.  
Gross Profit Formula




  • Gross Profit Margin. This is the amount of gross profit you make as a percentage of the revenue the business makes. Working out this percentage is very useful for several reasons. One is that you can use it to compare to other businesses. If other businesses have a higher gross profit margin, this indicates you are likely to be able to either (or both) lower your cost of goods sold or increase your prices. Looking at your gross profit margin is particularly useful when you are making decisions around what prices to charge and whether or not you can afford to offer customers discounts.
Gross Profit Margin Formula




  • Net Profit Margin. This measures the amount of profit made for every sale you make. Increasing profitability is about increasing the net profit margin. Profit is not the same as profitability. It is possible to increase your business profits, but have a lower net profit margin – this happens if you spend a relatively large amount of money in order to increase your sales. Your aim should be to either maintain or increase your net profit margin as you increase your sales.
Net Profit Margin Formula





Tip

Use your gross profit margin and your net profit margin as key performance indicators (KPIs).

Calculate these margins for each year you have been in business so far (or for the time you have been operating). Then set a target for each for current or upcoming year. Every month, monitor your progress towards achieving your targets.

Other Ratios

There are many other ratios you can calculate from a profit and loss statement which you can use to monitor your profitability. However, for some of these ratios, the resulting information is very similar to that already given by the gross profit margin and net profit margin. It can therefore be a good idea to simply focus on a couple of key margins.

In any case, some ratios you may find useful include:
  • Expenses to Sales Ratio, calculated as expenses divided by sales (x 100). If your ratio is increasing over time, your expenses may be getting out of control. If your advertising costs have increased during this time, perhaps your advertising costs more than the sales it generates.

  • Wages to Sales Ratio, calculated as total wages divided by sales (x 100). This shows you the percentage of revenue taken up by wages. If it is very high, it shows that a large percentage of revenue is taken up by wages: you might have to think about lowering your wage costs. However, you need to compare this figure to what is normal in your industry as some industries are naturally labour intensive. Wood for a wood carving business is generally quite cheap, so most of the cost of making a wooden sculpture comes from paying the carver’s wages.

Tip

Comparing your ratios and margins to industry benchmarks will help you identify where you need to make changes. For example, if your gross profit margin is lower than others in the industry, but your expenses to sales ratio looks good, this indicates you need to focus on reducing your cost of sales. Research to find out whether there are cheaper supplies available or try to negotiate a better deal with your current suppliers.

Some industry benchmarks can be found on the IRD website.