Does your sales revenue exceed your expenses? If so, there’s a good chance your cash flow is positive and your business is making a profit.
Profitability is a key objective for every business owner. But looking at your profits solely as a dollar amount means you’re only seeing part of the picture. It can’t tell you why your business is profitable, for example, or how sustainable that financial state is.
By converting different types of profit (like the company gross profit, operating profit, and net income on your income statement) into margin ratios, you can measure your financial efficiency - and compare your performance with competing businesses – far more effectively.
In this article, we’ll show you how to calculate and analyze your gross, operating, and net margins as profitability ratios.
Gross Profit Margin Ratios
Your gross profit is equal to your total revenue, less the direct costs (including materials, direct labour, packaging, and shipping) of producing your goods.
Gross Profit = Net Sales – Cost of Goods Sold (COGS)
Gross Profit Margin = (Gross Profit / Sales) x 100
Here’s an example of the gross profit margin ratio in action.
The Simple Deli sells sandwiches and coffee. For the fiscal year ending December 31, 2020, they reported total sales of $564,920, and COGS of $125,00 on their income statement. Based on those numbers, their gross profit was $439,920, and their gross margin was 77.87%. That means, for every dollar The Simple Deli generated in sales, they generated 77 cents in gross profit before other business expenses were paid.
By looking at your direct costs only, gross profit margin shows how financially efficient your business is at turning raw materials and production labour into the goods or services you sell. Generally speaking, the higher your gross margin, the higher your profits.
You can also use a product or service’s gross margin to determine its profit potential. Here’s how that works.
The Simple Deli’s total sales in 2020 consisted of $505,400 in sandwich sales, and $59,520 in coffee sales. With a food cost of $106,400, and a beverage cost of $18,600, their gross margin on sandwiches was 78.95%, while their gross margin on coffee was 68.75%. In view of their coffee’s lower margin, the company could look to reduce their cost through bulk purchases or to increase their markup per cup.
Operating Profit Margin Ratios
Your operating profit is equal to your total revenue, less your COGS, operating expenses (including selling and administrative expenses), and depreciation & amortization.
Operating Profit = Gross Profit – Operating Expenses – Depreciation & Amortization
Operating Profit Margin = (Operating Profit / Sales) x 100
Here’s an example of the operating profit margin ratio in action.
For the fiscal year ending December 31, 2020, The Simple Deli reported total sales of $564,920, and a gross profit of $439,920. Their operating expenses for the year were $318,960. Based on those numbers, the company’s operating profit was $120,960, and their operating margin was 21.41%.
By taking all your costs of doing business into account, operating profit margin shows how financially efficient your business is at controlling operational costs and expenses.
While an operating margin that trends higher over time is ideal, this ratio is mainly used to compare a company’s operations with those of its competitors.
Net Profit Margin Ratios
As the last line on your income statement, your net profit is literally your company’s bottom line – and one of the most important indicators of financial health.
Net Profit = Operating Profit – Interest – Taxes
Net Profit Margin = (Net Profit / Sales) x 100
Here’s an example of the net profit margin ratio in action.
For the fiscal year ending December 31, 2020, The Simple Deli reported total sales of $564,920, and an operating profit of $120,960. They also had income tax owing of $45,099. Based on those numbers, their net profit was $75,861, and their net margin was 13.43%.
Because it takes all your costs into account, net margin is the most granular and conclusive profitability metric.
While the ideal net margin varies with industry and company size, 10% is a decent average. Any ratio above the average for companies in the same industry, meanwhile, can be considered a competitive advantage.
If you want to improve your net company profit margin, you’ll need to increase sales, reduce expenses, or do both. Since higher sales often means higher total expenses, however, it can be worth outsourcing certain tasks - like bookkeeping or HR, for example - to cut costs.
Remember, just because your business is profitable dollar-wise, that doesn’t necessarily mean it’s financially healthy.
Using profitability metrics in conjunction with your historical data will help you:
- Conduct year-over-year comparisons
- Monitor your overall financial performance
- Make better, data-driven decisions
The only way to calculate and analyze your gross, operating & net margin ratios is with an accurate set of books.
If you need help bringing your financial data up to date, Enkel can help.