Home Articles Four Ways to Measure the Profitability of Your Business

Four Ways to Measure the Profitability of Your Business

All businesses love profit. That is the main reason why people open businesses. So much is done to get recognition, build a brand, market the products, and increase the visibility of that brand to get profit.

So the real way you can measure the success of your business is by measuring the profits. That is the only way to assess whether you are going in the right direction or not. How much profit is the business generating, is it better than last year’s profit or not?

According to a Gartner survey, less than 50% of all businesses have the kind of key performance indicators or metrics that help them recognize their achieved targets and whether they are successfully working towards their objectives or not.

Let’s look at some metrics that can help you find the profitability of your business.

  1. Gross Profit Margin

The Gross Profit Margin is an excellent way to determine the efficiency of your company. It is related to how your company builds or manufactures the products and then distributes them. It tells you about your costs and if they are the reason why your company is not making any profit.

There’s a simple formula to calculate your Gross Profit Margin:

Gross Profit Margin = (Company Revenue-Cost of Goods Sold)/Company Revenue

Let’s take a T-shirt company as an example. T-shirts are relatively economical, and they can help us understand the problem better. If you sell 1,000 T-shirts in a year and you sell them for $10 apiece, it means that your company has generated $10,000 in that year. Now you incurred a cost of $6 per T-shirt for the manufacturing and the distribution. As a result, the cost of goods sold is going to be $6,000.

If we put these values in the above formula, it would look something like this:

Gross Profit Margin – (10000-6000)/10000

The result comes out to be 40%. What this means is that your company is saving 40% profit each year. This is a healthy profit. You have a heap of cash to spend on marketing, research and development, and other things like taxes and more.

  1. Profitability Ratio

So, what is the profitability ratio?

These are the metrics that find out if a business, at a specific point in time, is capable of achieving earnings that are relative to its overall revenue, assets, shareholder’s equity, and operating costs. They also indicate if our existing assets are helping us generate profit.

We find out about the profitability ratio by comparing our results with other companies or our history.

They can easily tell you about your earnings during the season, and after the season, so you can make informed decisions later on in the future. If you want to compare the ratio with your company’s history, you can compare it with last year’s season. For example, if you found the profitability ratio in December, then you compare it with last December’s. You can’t compare it with January or any other time of the year.

  1. Return on Investment

Your company takes investment from an individual, or a group of people, and works on it to generate a profit. Return on Invested capital, as the name suggests, helps you find out if you are doing it right or not. You can use it to keep track.

The deeper you get into finding out the ROIC, the more complicated it can become. Here we take a simple formula of calculating return on invested capital to help you understand.

ROIC = Net Income/(Long-Term Debt + Equity)

The financial statement of your company can help you find out these values. Your net income is the bottom line of your income statement. Your balance sheet tells you about your exact total debt and your equity. If we take the example of Google, it earned around $12.2 billion in the year 2013. That is Google’s net income. Whereas, its total debt and equity came to be around $89.5 billion.

So Google’s ROIC is going to be 13.6%.

  1. Overhead Ratio

One of the things that tax business and its profits is the overhead cost. If you are having a hard time running your office and can’t meet the expense, you can have a hard time growing your business as well. The overhead ratio can be found out easily by using the following formula:

Overhead Ratio = Operating Expense/(Operating Income + Interest Income)

All you have to do is to look at your income statement to find out these elements. Your office rent, utility bills, equipment maintenance and upgrades, and other similar things are your operating expenses. They don’t give you any profit, but they are necessary for your business and your day to day routines.

For example, if we take Microsoft’s 2013 annual report, we find out that Microsoft had operating expenses of $30.8 billion. In 2013, it gained $26.8 billion operating income and $0.7 billion interest income. So Microsoft’s overhead ratio turned out to be 1.1.

What you have to do is to look at your gross profit margin and find out if your overhead ratio is sustainable or not. If your gross profit margin is low and your overhead ratio is high, then you need to lower your overhead ratio. Otherwise, you can be in big trouble.

If you find out these metrics and track them regularly, they can help you evaluate if your business is generating a profit or not and can also identify where you are going wrong.