When clients meet with Counting House Associates for business counseling, one of the first things we recommend is completing a profitability ratio analysis. Knowing the profitability of a company is essential to gauging its health and making future budgeting decisions. Investors also want to know how profitable a business is before they buy stocks. This blog discusses the two essential profitability ratios every business owner should understand.
Understanding Margin Ratios
The simplest way to express gross profit margin is by calculating the cost of goods sold as a total percentage of sales. This information should be easy to find on a company’s income statement. Margin ratios consider the efficiency of a company in containing its manufacturing and inventory costs and how much of the cost it passes along to consumers.
To help clients calculate gross profit margin, we deduct the total cost of materials purchased to produce goods. For example, assume that a business sold an item for $500. If it cost $250 to create the item, the gross profit margin would be 50 percent. We apply this calculation to all sales and the cost of goods sold to develop an overall gross profit margin for our client. Other considerations for margin ratios include:
- Cash flow margin: Calculating current cash flow involves dividing net sales by cash from operating cash flows to create a percentage. This is how much money the company has on hand or assets it could easily convert to cash within the next 12 months.
- Net profit margin: Also referred to as earnings before taxes and interest. The net profit margin considers the operating efficiency of an organization. This calculation also subtracts the expenses of ordinary business activity for a more accurate picture of profitability.
- Operating profit margin: Most companies use this figure when calculating a simple profitability ratio. The operating profit margin describes how much of every dollar remains as net income after deducting expenses.
Understanding Return Ratios
The indicator known as return on assets measures a company’s efficiency with managing assets and using assets to generate additional profits. Return on assets measures profit against a company’s investment level in total assets. To calculate the return on assets, we divide net income by total assets to arrive at a percentage.
Perhaps the most important figure for publicly-held companies is the return on equity. This figure demonstrates the typical return on investment people have earned from buying stocks in the company. Prospective investors often look for this figure first when deciding whether they want to invest in a business or not.
We need access to a client’s income statement to locate net income and balance sheets to find the stockholder’s equity for this calculation. Return on equity is equal to the sum of net income divided by the stockholder’s equity expressed as a percentage.
These are just some of the many calculations we help clients make during business counseling sessions. We invite business owners to schedule a free consultation to learn more about how working with Counting House Associates can increase their bottom line.