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How to Measure Your Business's Profitability

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This post is part of a series called Key Metrics Every Business Should Track.
Pivotal Liquidity Metrics to Help You Avoid Insolvency

You are what you measure.

Many businesses generate reams of stats, metrics and key performance indicators, but if you’re not measuring the right things, you won’t get the right results.

The point of measuring performance, after all, is not to see how you did in the past, but to use that information to do better in the future. A recent Gartner survey found that less than half of businesses have metrics that help them understand how their work contributes to achieving their strategic objectives.

So in this four-part series of tutorials, we’re going to look at the critical metrics your business needs to track in key areas: profitability, liquidity, efficiency and customer acquisition/satisfaction.

First up is a look at profitability metrics. As with all the other areas, there are dozens of possible metrics you could track, but we’re going to focus on four of the most important ones, and look in detail at how you calculate them, what the results can tell you about the health of your business, and most importantly, what action you can take to improve your results in the future.

A lot of the numbers we’re looking at in this tutorial will come from your company’s income statement. If you need a refresher on what any of them mean or where to find them, check our recent tutorial on reading an income statement.

1. Gross Profit Margin

Why It’s Important 

This number is a good basic measure of how efficient your company is at manufacturing and distributing its products. It helps you zero in on your costs, and how much they’re eating into your profits.

How to Calculate It

The formula for this one is quite simple:

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

For example, let’s say your company sold 1,000 T-shirts for $10 each. Your revenue for the year would be $10,000. But each T-shirt cost $6 to manufacture and distribute, so the cost of goods sold is $6,000. We plug in the numbers and get:

Gross Profit Margin = (10,000 – 6,000) / 10,000 = 40%

How to Evaluate It

In this example, your company is keeping 40% of the proceeds of each sale as profit, which is pretty healthy. That means it has plenty of money left to cover other costs, like research and development, taxes, and general administrative costs.

But keep in mind that gross profit margins vary widely by industry. Service-based businesses like law firms and accountants usually have high gross profit margins (50% and up), whereas manufacturers and retailers tend to be more in the 20% to 30% range. 

This website shows average gross profit margins for various industries, and you can also check with industry associations in your particular field for more information. Once you’ve established a benchmark, see how you compare against it, and how the percentage is changing over time.

How to Improve It

If your business is suffering from lower gross profit margins than your competitors, there are several things you can do. The most straightforward is to raise your prices. A bigger markup on each sale will translate to a higher gross profit margin, although of course you need to be careful not to drive away customers, so do your research to see how much the market will bear. An alternative is to look at your product mix, and spend most of your marketing dollars on pushing the high-margin products.

Or you could target the cost side of the equation. Can you switch to a cheaper supplier, or negotiate a better rate with your existing supplier? If you’ve been doing business for a while and growing, you may be able to negotiate a volume discount, lowering your costs and increasing your margin. Or perhaps the problem lies in your own processes. Examine every detail of your manufacturing and distribution processes to see if there are opportunities to make them more efficient.

2. Return on Invested Capital

Why It’s Important

One of the most basic things that companies do is to take money that’s been invested (capital), and turn it into profit. Return on Invested Capital is a measure of how effectively your company is doing that, and so it’s crucial to keep track of.

How to Calculate It

Working out ROIC can be either very simple or very complicated, depending on how much detail you want to go into.

Let’s look at the simple method first. The simplified formula is:

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

These are all numbers you can find easily on your business’s financial statements. Net income is the “bottom line” number on the income statement, and total debt and equity are on the balance sheet.

Google, for example, earned $12.2 billion in net income last year, and its total long-term debt and equity came to $89.5 billion.

So it’s ROIC would be 13.6% (12.2 divided by 89.5).

Some people like to make it more complicated, however. They make lots of adjustments to net income, mostly to take out any items that are unlikely to recur, arriving at a figure called NOPAT (net operating profit after tax). And they adjust debt and equity to get a more accurate picture of what’s actually invested in the business, as opposed to things like surplus cash.

Those adjustments can make a significant difference. Google’s ROIC, according to Marketwatch, is 14.9%. Morningstar makes it 15.1%.

What’s right for your business depends on how deep you want to get into the details. Just remember that the idea is to see how much profit you’re generating from the capital you’ve invested, and that if you’re comparing with other companies, they may be using slightly different methodologies.

How to Evaluate It

As with the other measures, the important thing is to look at your ROIC in comparison to your own results in earlier years, and also in comparison to your competition. For public companies, you can easily find the ratio in the companies’ accounts or on financial websites. Look at a few examples in your industry to get an idea of what to aim for. As a very rough rule of thumb, an ROIC of 15% or higher indicates a healthy amount of profit, but it varies for different industries.

How to Improve It

You can drive your ROIC higher in a number of ways. You could focus on the top part of the equation, the net income. Cutting expenses will give an immediate boost to net income, and therefore to ROIC, but be careful not to take it too far and starve your business of necessary investment. You could also do a sales drive to increase revenue, or try to shift your sales mix to more profitable products.

You could also choose to focus on the bottom part of the equation, debt and equity. Are you making the maximum use of all your capital? If not, then you can choose to pay down debt or return money to investors, which will also boost your ROIC.

3. Overhead Ratio

Why It’s Important

Overhead costs can be a real drag on a business’s profitability. If you’re spending a big portion of your income just keeping the lights on, you’ll struggle to grow. We looked at costs associated with sales in the “gross profit margin” section, and this is the other piece of the puzzle: fixed overheads.

How to Calculate It

You can calculate your overhead ratio using the following formula:

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

Again, these are all lines from the income statement. Operating expenses are the “overheads,” things like office rent, utilities, machinery maintenance and so on. They’re necessary for your business, but they don’t directly generate income.

We’re then dividing that number by operating income (which you find on the income statement) plus interest income from your business bank account or investments.

For example, Microsoft had $30.8 billion in operating expenses, according to its 2013 annual report. It earned $26.8 billion operating income and $0.7 billion interest income. So the calculation would be:

Overhead Ratio = 30.8 / (26.8 + 0.7) = 1.1

How to Evaluate It

It’s best to look at this in conjunction with gross profit margin. Microsoft has a strong gross profit margin of 74%, so it has plenty of money left over for other costs. It’s overhead ratio, then, is sustainable.

If your business has a smaller gross profit margin, on the other hand, you’ll need to keep a much tighter lid on expenses.

As with the other ratios, the right number depends a lot on which industry you’re in, and what other companies in your field are doing. Go through the accounts of public companies in your field, companies whose success you want to emulate, and see how your company’s overhead ratio compares with theirs.

How to Improve It

This is a simple one to improve: simply cut expenses. But you need to be careful. Although overheads don’t contribute directly to generating revenue, they can still be important for your business.

Some operating expenses, for example, could be research and development costs, or advertising spending. Cutting office rental costs by moving to a smaller building in a cheaper neighborhood may be a smart move, but slashing your marketing budget could harm your company’s future sales. Laying off admin staff will save money in the short run, but might end up costing you more if it leads to inefficient invoicing or missed customer calls. So you want to trim overheads enough to be competitive, but without sacrificing quality.

4. Asset Turnover

Why It’s Important

There are different ways of making money. Some businesses, like Walmart and other discount retailers, have low profit margins but a high volume of sales. Asset turnover measures how efficiently your business uses its assets to generate sales.

How to Calculate It

This is a nice simple one to end with. It’s simply:

Asset Turnover = Total Revenue / Total Assets

Your revenue number, of course, is the top line from your income statement. It’s the total amount of sales you brought in over the year. Total assets are just the sum of all your property, equipment, inventory and so on, and you can get that number straight from the balance sheet.

A look at Walmart’s 2013 annual report shows that it had revenue of $469.1 billion and total assets of $203.1 billion. That means an asset turnover of 2.3.

How to Evaluate It

It’s important to compare like with like. Let’s go back to Microsoft. Its asset turnover is just 0.5, much lower than Walmart’s. But it’s still a profitable business, thanks to that high profit margin we saw earlier.

So look at the numbers together with the other ratios we’ve looked at in this tutorial, and see how they fit together. Then think about your business model, and the industry you’re in, and decide on a target asset turnover that’s right for you.

How to Improve It

Even if you’re not running a Walmart-style high-volume business, improving your asset turnover will still improve your profitability. How to do it? This is the only ratio we’ve looked at where cost is not part of the equation, so in this case it’s all about driving top-line sales growth. Consider things like ad campaigns, special promotions, loyalty programs, undercutting your competitors on price, or paying special incentives to your sales staff.

Also think about speed. Remember, asset turnover is about converting assets into revenue as efficiently as possible. So no matter what type of business you run, look at ways to streamline your processes and get your products to market more quickly.

Next Steps

If you look at one of these metrics on its own, it’s of limited use. Take them all together, and you have a clear picture of your business’s profitability.

You’ve now learned what these metrics are and how to calculate them, and what the results tell you about the health of your business.

So the next step is to start using them on a regular basis. Start by looking at your historical numbers, going back perhaps five years if possible. One of the main benefits of tracking metrics is in seeing changes in your business over time. Is your overhead ratio creeping up year by year? Maybe this is the year to get those costs in check. Is your gross profit margin declining? Perhaps you need to examine your product mix and push the ones that carry a higher markup.

Of course, you shouldn’t look at any of the numbers in isolation. If there’s a good reason why your asset turnover is lower than your competitorsperhaps because you have higher profit marginsthen you don’t have to try to match them just for the sake of it. If your overheads are high, but that’s because you’re spending money on essential research that will pay off over the long term, then there’s no sense in making damaging cuts.

When taken in the right context, though, and tracked consistently, these metrics can help you see where your business is profitable, where any problems lie, and what actions you need to take to boost your bottom line.

In the rest of our four-part series, we’ll look at a range of other metrics to track in different areas of your business, starting next week with some key liquidity metrics to make sure you stay solvent.

Resources

Graphic Credit:  Line Graph designed by Scott Lewis and  Abacus designed by Berkay Sargın from the Noun Project.

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