ComplianceLegalFinanceJanuary 09, 2021|UpdatedFebruary 19, 2021

# Measuring profitability through the use of various performance ratios

Investors (including yourself) will be interested in these ratios insofar as they demonstrate the performance and growth potential of the business. As far as performance ratios that matter most to small business owners are concerned. You'll want to focus on:

• Gross Profit Margin Ratio
• Net Profit Margin or Net Profit Percentage
• Operating Profit Percentage
• Return on Assets
• Return on Equity

## Understanding Your Gross Profit Margin Ratio

Your gross profit margin can be calculated with the following formula, using figures taken from your income statement:

### Gross Profits / Sales = Profit Margin

Recall that gross profit is the amount of sales dollars remaining after the cost of goods sold has been deducted.

If your gross profit margin is declining over time, it may mean your inventory management needs to be improved, or that your selling prices are not rising as fast as the costs of the goods you sell.

If you are a manufacturer, for example, a decline may mean that your costs of production are rising faster than your prices, and adjustments on either side (or both) are necessary.

## Understanding Your Operating Profit Percentage

The operating profit percentage can be calculated using the following formula, with figures taken from your income statement:

### Operating Income / Sales = Profit Percentage

This ratio is designed to give you an accurate idea of how much money you're making on your primary business operations. It shows the percentage of each sales dollar remaining after all normal costs of operations. By looking at this ratio over time, you can get a fix on whether your overall costs are trending up or down.

## Understanding the Net Profit Margin

Your net profit margin shows you the bottom line: How much of each sales dollar is ultimately available for you, the owner, to draw out of the business or to receive as dividends.

It's probably the figure you are most accustomed to looking at. This ratio takes into account all your expenses, including income taxes and interest.

Example

If your net income is \$500,000 and sales are \$2,000,000, your profit margin is 25 percent. (500,000 / 2,000,000 = 0.25. Expressed as a percentage, this is 25 percent.)

You should have some idea of the range within which you expect your profit margin to be, which will be determined in large part by industry standards. If you fail to meet your target, it could mean that you've set an unrealistic goal, or it could mean that you're doing something wrong.

Bear in mind, though, the ratio itself will not point to what you may be doing wrong. Looking at your gross margin or operating margin is a better way to get a fix on the problem.

Even if you meet your goal, you should always keep an eye on your profit margin. If it should decline, for example, it may indicate that you need to take a look at whether your costs are getting too high.

## Understanding Your Return on Assets

Return on assets is the ratio of net income to total assets. It is basically a measure of how well your business is using its assets to produce more income. It can be viewed as a combination of two other ratios:

• Net Profit Margin (ratio of net income to sales)
• Asset Turnover (ratio of sales to total assets)

A high return on assets can be attributable to a high profit margin, a rapid turnover of assets, or a combination of both.

 Net Income Sales × Sales Total Assets = Net Income Total Assets

## Understanding Your Return on Equity

The return on equity ratio can be calculated using the following formula:

 Net Income Owner's Equity

The ratio of net income from the income statement to net worth or stockholders' equity from the balance sheet shows you what you've earned on your investment in the business during the accounting period. Bankers often refer to this ratio as return on investment (ROI).

You can compare your business's return on equity to what you might have earned on the stock market (or even a simple bank account) during the same period. Over time, your business should be generating at least the same return that you could earn in more passive investments like stocks, bonds, and bank CDs. Otherwise, why are you spending your time, trouble and capital on it?

A high return on equity may be a result of a high return on assets, extensive use of debt financing or a combination of the two.

Tip

If you're assessing return on equity for a corporation, keep in mind that net income reflects your expenses for any salary paid to yourself or other owner-employees.

Because many shareholder-employees of closely held corporations — for tax purposes — draw the highest salaries possible, return actually may be higher than indicated by this ratio. Inventory policy and the policy of the business on the treatment of borderline expense/capital items also can have a significant impact on this ratio.

In analyzing both return on equity and return on assets, don't forget to consider the effects of inflation on the book value of the assets. While your financial statements show all assets at their book value (i.e., original cost minus depreciation), the replacement value of many older assets may be substantially higher than their book value. A business with older assets, generally, should show higher return percentages than a business using newer assets.

Operations Manager