The goal of any small business is to be profitable. But for the average business owner who isn’t 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.
We’ll go over the best ways for you to measure the profitability of your small business. Don’t get intimidated by technical terms and big numbers. Figuring out how to measure your business’s 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 business’s profitability to grow and prosper.
What’s the Difference between Profit and Profitability?
Before we dive into figuring out how to measure your business’s profitability, we should establish the difference between profit and profitability. The two words sound similar and are often used interchangeably, but they’re 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 business’s 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 Business’s Profitability
Now that we have a basic understanding of the difference between the two, let’s look at four ways you can measure your small business’s profitability.
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, you’ll 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 measure your business’s efficiency much easier than looking at a dollar amount.
Determine Your 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 shouldn’t 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. What’s 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
Some of your clients may be more profitable than others. To effectively determine your profitability, you’ll 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 doesn’t mean they’re 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. You’re not losing money, but you’re 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.
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 you’ve 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 you’re operating.
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 you’re 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 isn’t, 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 you’ve invested.
Plan Ahead to Ensure Your Small Business Stays Profitable
As a small business, it can be difficult to juggle the financial aspects of your company if you’re 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 future is 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 business’s profitability? Drop a comment below with your tips!