How to calculate gross profit margin, operating profit margin and net profit margin? Why are understanding ratios important? Margins are expressed as ratios, such as gross profit ratios. Profitability ratios provide a quick view of the health of your business.
You need to thoroughly understand and carefully monitor your business financials to help you succeed in business. This is even more necessary in today's economic climate.
As a business owner, you need to understand financial ratios as a reporting tool; in particular, understand gross margin and why it is an important profitability measure for you to follow.
You also need to understand how your business' gross margin compares to others in your industry; as this enables you to benchmark your business against the best in your market and to manage for improvement.
What is gross profit ratio and margin? How can understanding gross margin help you better manage your business?
Gross margin is also known as gross profit, gross margin and gross profit ratio:
gross margin is expressed as a percentage;
gross profit is expressed as dollars;
gross profit ratio is expressed as a quotient (the result of one number being divided by another).
Profitability ratios measure the income of your business during a defined time period; there are other profitability ratios, such as return on equity ratio, return on assets ratio, net profit margin ratio (also known as profit margin ratio), asset turnover ratio, operating expenses to sales ratio, cash return on sales ratio, and gross margin (or gross profit margin) ratio.
If you are an incorporated company and your company has issued common and/or preferred shares, other profitability ratios of interest are return on common stockholders' equity ratio, earnings per share, price earnings ratio and payout ratio.
Your lenders will want to know your gross margin and how you compare in your industry; they use this information to assess the health of your business (and industry).
However, financial ratios individually do not provide a full and detailed picture of the health of the business; other ratios to review are liquidity and solvency ratios. This discussion focuses on gross margin as a key profitability ratio.
Gross Profit Margin = Sales Revenue minus Cost of Goods Sold (COGS) divided by Sales Revenue
For example, if your company earned $100,000 in sales revenue and incurred $60,000 in COGS (costs), your gross profit would be $40,000 and your gross margin ratio would be 40%. For every dollar in sales, you would have $0.40. Remember however that COGS does not include all costs so that your profit margin is really a quick measure, not a full measure of profitability.
I strongly recommend that all business owners develop a peer network or business community to help them establish non-competitive relationships; you can share information with each other to help you build a stronger business.
Additionally, most industries have associations related to the industry; check with your industry association and compare your business performance.
Gross profit margin is a good measure of your ability to sell your product or service at a specific rate above your cost of goods sold.
Often gross margins are higher in non-competitive markets (during the introductory and growth stages of a product's life-cycle) but as more competitors enter the market there is downward pressure on price and on profitability (this typically occurs during the mature and declining service or product life cycle stage). You must therefore manage your business costs to more efficiently produce your product or service; thereby lowering your cost of goods sold.
Operating profit margin, also known as net profit margin, is another measure of efficiency and profitability. A higher operating profit margin (than your competitors and/or your industry) typically means that your business has lower fixed costs and a higher gross margin. With a higher operating profit margin, you could use it to utilize competitive pricing strategies and provide price flexibility in slow market conditions.
Operating Profit Margin = Operating Income divided by Total Sales Revenue
Economic profit is sometimes confused with accounting profit, which is also not the same as gross profit. Make sure that you understand the terminology as best as possible so that you can compare your performance to industry performers correctly. Economic profit is more commonly known as economic value added (Economic VA) and is a measure of economic value for shareholders.
Economic VA = Net Operating Profit (after taxes) minus (Capital times Cost of Capital: i.e. the opportunity cost of capital)
Net profit margin includes all parts of the business expenses and revenues (including taxes). This ratio compares net income with sales.
Net Profit Margin = Net Profits (after taxes) divided by Sales Revenue
Opening a small business and managing your business growth is only one aspect of your business' success. You need to understand your business financials, such as what is cash flow, how to manage cash flow, and why it is important to your business health; how to calculate profit and ensure you maximize profit; how to manage your working capital; if you're looking for money to startup or to expand, you need to know how to obtain startup financing; and so on.
Analyzing and understanding profitability ratios (and in particular, gross profit margin), is only one of many aspects of your business financials; but it is a very important one.
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Getting financing for starting up your new business is a challenge.
But just as challenging is ensuring that you have enough financing to operate your business.
Most businesses do not have a steady flow of cash incoming (or outgoing); it comes in 'fits and starts' no matter how much we try to plan for consistency in cash flow.
You need to ensure that you forecast your cash flow needs realistically and that you are on top of your accounts receivable; do not let your customers use you as their bank (by extending long payment terms), especially during the start up years of your business when every dollar is important to your success.
Make sure that you are clear in setting up new customer accounts: tell your customers what you need and expect in terms of payment (for example, cash on delivery (COD), 15 days from date of invoice, a deposit on order and balance on delivery, etc.).
However, also make sure that your invoice terms are competitive for your industry; check out what your competitors offer and make sure that your terms are competitive. For example, if you want payment in a shorter time frame than your competitor offer an incentive for that earlier payment: perhaps a discount of the next order, or a rebate, or a gift.
Merchant 'advances': from companies that lend money on credit card cash flow rather than collateral;
Accounts receivables or trade financing: from 'factoring' companies that buy and assume the ownership for the invoice from a customer;
Raise money through preferred shares (non voting) or common shares (voting) in your limited company;
Subordinate financing: typically a higher interest (because it is higher risk) loan based on cash-flow and receivables, rather than on assets.
For each of these alternatives, talk to your accountant and your banker: even if the banker isn't loaning you the money, they can provide valuable input and advice.