What is the best way to measure profitability?

What is the best way to measure profitability?

Four Ways to Measure Profitability to Grow Your Small Business     Melinda Emerson, MBA

Melinda Emerson, MBA

Bestselling Author, Marketing Consultant, Small Business Expert, Keynote Speaker, Social Selling Expert, Media Personality,  Educator, LinkedIn Top   Published Jun 15, 2021           + Follow

The goal of any small business is to be profitable. But for the average business owner who isnt well versed in determining the financial health of their business, how can they measure their profitability? While there are many different reports you can run, it can be difficult to know what numbers you should track.

Well go over the best ways for you to measure the profitability of your small business. Dont get intimidated by technical terms and big numbers. Figuring out how to measure your businesss profitability ensures you stay on the track to success. You need to know how financially sound your business is, so you know what to expect for the future.

Read on for more information on how to use your businesss profitability to grow and prosper.

Whats the Difference between Profit and Profitability?

Measure Profitability to Grow Your Small Business profit & profitability

Before we dive into figuring out how to measure your businesss profitability, we should establish thedifference between profit and profitability. The two words sound similar and are often used interchangeably, but theyre not the same thing.

Profit and profitability are defined as follows:

  • Profit:The amount of income your business makes beyond the expenses or costs you incur. You calculate this by taking your total revenue and subtracting out your total amount of expenses. You can also find this number on your income statement.
  • Profitability:Profitability is a relative amount, while profit is absolute. Profitability looks at how a business is performing overall. It measures a businesss profits, giving you a percentage that can help you forecast and analyze how successful your business is.

Profit is concerned with hard numbers, whereas profitability is more abstract. You want to be able to determine if your small business is generating more revenue than expenses.

How to Measure Your Small Businesss Profitability

Now that we have a basic understanding of the difference between the two, lets look at four ways you canmeasure your small businesss profitability.

Measure Profitability to Grow Your Small Business 4 ways

1. Run Your Margin or Profitability Ratios

Running your margin ratios is one of the best ways to determine if your business is profitable. But, to do that, youll need to calculate three different things from your income statement:

  • Net Sales  Cost of Goods Sold = Gross Profit
  • Gross Profit  (Operating Costs, Including Selling and Administrative Expenses) = Operating Profit
  • (Operating Profit + Any Other Income)  (Additional Expenses)  (Taxes) = Net Profit

These three figures will help you see what your profit is from a dollar perspective. We can analyze these numbers further by turning them into ratios.Ratios help you measureyour businesss efficiency much easier than looking at a dollar amount.

Determine Your Profit Ratios

Measure Profitability to Grow Your Small Business profit ratios

For businesses that sell physical goods, your gross margin helps you see if your products are profitable.

To calculate your gross profit margin ratio, use the following calculation:

(Gross Profit ÷ Number of Sales) X 100 = Gross Profit Margin Ratio

If your margin is high, that means you made a lot of profit compared to how much your products cost. Your margins shouldnt fluctuate from one quarter to the next. They should remain stable.

For your operating margin, you want the ratio to increase over time. That shows that your company is healthy and growing. Use the following calculation:

(Operating Income ÷ Number of Sales) X 100 = Operating Profit Margin Ratio

If this number stays the same for some time, it might be because your operating costs have increased. Look at how much your operating expenses are to see if you can decrease the amount.

Your net profit margin, or profit margin, gives you the full scope of your profitability. For calculating your profit margin, use the below calculation:

(Net Income ÷ Number of Sales) X 100 = Net Profit Margin Ration

Your net profit margin shows you how much money your company can make from your sales. Whats different about it from your operating profit margin is it includes earnings you receive after taxes. Some businesses have a high profit margin, while others have smaller ones.

2. Check Your Profit per Client

Measure Profitability to Grow Your Small Business profit per client

Some of your clients may be more profitable than others. To effectively determine your profitability, youll need to know which of your clients are making the largest contribution to your total profit. Even if a client pays a big fee, that doesnt mean theyre the most profitable.

Use the below calculation to determine your profit per client:

Total Project Fees  Project Expenses = Gross Profit per Project

Gross Profit per Project / Hours Spent on Project = Hourly Wage

Look at the hourly wage you earn for each project. Focus on bringing in more clients and projects that give you a higher wage per hour. A client may pay a high fee per month, but you also may be devoting a large chunk of hours to them, making them not profitable for your business.

3. Analyze Your Break-Even Point

When your business breaks even, that means your revenue and expenses are the same. Youre not losing money, but youre not making any either. You need to evaluate what your break-even point is so you know the moment when things take a downward trend with your business. You need to plan for the unexpected with your small business, allowing yourself breathing room when you can.

Measure Profitability to Grow Your Small Business break even point

To figure out your break-even point, use the below calculation:

Fixed Expenses + Variable Expenses = Break-Even Point

Another way to calculate your break-even point is to measure it against how many units youve sold. Do so by using this calculation:

Fixed Expenses ÷ (Unit Sales Price  Unit Variable Expenses) = Break-Even Point for Units Sold

Calculating this number will help you figure out how much profits you can afford to lose before your company is no longer profitable.

4. Evaluate Your Return on Investments and Return on Assets

Return on assets (ROA) shows you your total revenue compared to the total amount of assets used. You can compare this number from quarter to quarter at your company. The higher your ROA is, the more efficiently youre operating.

Measure Profitability to Grow Your Small Business roi

Use this calculation:

(Net Income Before Taxes ÷ Total Assets) X 100 = ROA

Your return on investments (ROI) illustrates how much your company is earning compared to your investments. You want to ensure that youre investing your money in the right places. Your ROI should be as high as a risk-free investment, like a CD or high-yield savings account. If it isnt, then it may be a better decision to invest your money in one of those types of accounts.

The calculation for ROI is:

Net Profit Before Tax ÷ Net Worth = ROI

All of the investments and assets in your company should be low risk. You want to ensure that your business is stable and not at risk of losing the money that youve invested.

Plan Ahead to Ensure Your Small Business Stays Profitable

Measure Profitability to Grow Your Small Business plan ahead

As a small business, it can be difficult to juggle the financial aspects of your company if youre not well versed in it. However, with the help of a few calculations, you can have a clear view of how profitable your business is.Planning for the futureis key to the success of your business. Look at your list of clients and projects for the year, and if you notice any light periods, get started on lining up new business.

Do you have any other ways you measure your businesss profitability? Drop a comment below with your tips!

For more great tips to run your small business, visit the Succeed As Your Own Boss blog and check out the #SmallBizChat Podcast.

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