Sometimes a company looks successful: every month it opens a new branch, hires a second thousand employees, and never leaves the front page of Forbes. But then it goes bankrupt. It happens when the owner looks only at the scale of the company or turnover, and these are not the indicators that really reflect the financial health of the business. Here are the most essential factors.
Profitability by Margin
Profitability by margin shows what percentage of revenue a company keeps for itself and what percentage it spends on producing goods or providing services.
Profitability by margin is calculated using this formula:
(margin profit / revenue) * 100%.
Marginal profit is revenue minus variable costs, that is, those costs that appear when the company receives an order. For example, the atelier receives an order for a dress – the atelier buys fabric and buttons. There is no order for the dress – there are no expenses for fabric and buttons, so this expense is variable.
Profitability by margin is looked at in the dynamics: if from month to month it grows, then everything is fine. If it drops, it means you need to reconsider variable costs.
Profitability by Gross Profit
Gross profit margin shows how well different lines of business are performing. For example, if a coffee shop has several outlets, the gross profit margin will show which of them brings the most profit, and which one it is time to close.
Gross profit margin is calculated as follows:
(destination gross profit / destination revenue) * 100%.
Gross profit is the revenues of a separate line minus variable and general production expenses of the same line.
For example, a sportsbook website has three lines: live match broadcasts, betting with a sports betting online, and advertising. To understand which line is more profitable, the company calculates the profitability of the gross profit separately.
If the gross profit margin is falling or is low compared to other areas, look for the reason, for example, to check the variable costs or the production costs. Perhaps something needs to be closed.
Operating Profit Margin
Operating profit margin shows how the company is affected by fixed costs. Fixed costs are those that the company incurs regardless of the number of orders, such as office costs, salaries, and advertising.
Operating profit margin is calculated like this:
(operating profit / revenue) * 100%.
Operating profit is revenue minus variable and fixed costs.
If the operating profit margin is falling, then you need to diagnose your fixed costs. Maybe it’s time to give up the fancy office and lower someone’s salary.
Net Profit Margin
Net profit margin shows what proportion of revenue becomes net profit. This figure protects against the illusion of a huge turnover. For example, we have made a turnover of $100 million, so we have done another best!
But perhaps the turnover was made at the expense of “zero” or unprofitable deals: we sold very cheaply, got huge revenue and no profit. To prevent this from happening, you need to calculate profitability by net profit.
They calculate it this way:
(net profit / revenue) * 100%.
Net profit is revenue minus all of the company’s expenses: variable, fixed, taxes, depreciation, and payments on loans.
If the net profit margin is falling, but there are no problems with other types of profitability: gross, operating, margin, then the reason must be sought in loans or taxes. Maybe it is the profit tax or the enormous interest on the loans that is eating up all the profits.
Return on Assets
Return on assets shows how many dollars of net profit a dollar of assets makes. Assets are all of the company’s real estate, equipment, raw materials, finished goods, and stocks in warehouses.
Return on assets is calculated as follows:
(net income / assets) * 100%.
It is okay if the return on assets drops after you buy new equipment or expand your business. But if it does not start to grow within three months after that, it means that the new assets are not profitable.
The Turnover Ratio
Working capital is the company’s money in the form of inventory and the difference between accounts receivable and payable. And it takes time for this money to turn into normal money: in some businesses the transition takes a day, in some it takes five years – this time is called the turnover period.
To calculate this period, the working capital turnover ratio is used:
revenue / working capital.
There is no universal coefficient. It all depends on the type of company, for example for a trading company with large inventories a turnover ratio of 1.1 would be excellent. And for some consulting firm – unacceptably low.
The break-even point is a state of business when the company does not make a profit, but also does not incur losses. Simply put, expenses are equal to revenues, and profits and losses are zero.
The break-even point is considered as follows:
(general production + indirect costs) / marginal profit margin * 100%.
The break-even point is an absolute indicator, not a relative one, it does not need to be compared with indicators for other periods, but it is important to count each month. It is normal if the break-even point grows together with the company.
Revenue and Profit per Employee
Revenue and profit per employee are ratios that show how much money each employee brings to the company. Often entrepreneurs count this only for sales managers, but actually even the cleaning lady contributes: if she wasn’t there, managers would have to mop the floors, and they would waste the time in which they can bring in new customers.