How to measure the profitability of your business is very important for good decision-making. Measuring the profit is not for just annual reporting or tax purposes. However, profitability is one of the vital tools to measure the financial performance of an organization. It measures the ability of the organization to utilize its resources in generating a profit and enhancing shareholders’ wealth.
Profitability is the ability of an organization to generate a return on investment. The main goal of every business organization is to make a profit. So, profit is the difference between the company’s revenue and cost. A company that can’t earn profit won’t be able to survive in the highly competitive world in the long run. There are many ways to measure the profitability of a business, but this article explains 3 ways of measuring the profitability of a business.
How to Measure the Profitability
The three ways to measure the profitability of a business organization include the following:
This measures the ability of the organization to generate profit from its revenue. So, it is the ratio of profit against revenue. Different stakeholders make use of profit margin to evaluate the financial performance and growth potential of a company. The profit margin can be divided into the gross profit margin, operating profit margin, and net profit margin.
Gross profit margin
This is the gross profit expressed as a percentage of sales or net sales. Gross profit is the difference between the sales or net sales and the cost of goods sold (COGS). However, the cost of goods sold is the cost that can be directly traced to the goods sold. I.e. it is the direct cost of the business. It includes direct material, direct labor, and other direct costs. You can use the gross profit margin to measure the ability of the business to pay its operating overheads, interest, and tax. It can also be used to predict the growth potential as well as inflows and outflows of the business.
Operating profit margin
Operating profit margin is the profit before interest and tax expressed as a percentage of sales. It measures the profit that a company generates from its core business or ordinary course of business. It is also known as profit before interest and tax (PBIT). So, it is gross profit minus operating expenses such as selling and distribution, administrative and general expenses excluding interest and tax. It helps the company to determine its ability to pay non-operating expenses such as interest and tax.
Net profit margin
Net profit margin is the net profit expressed as a percentage of sales or net sales. It measures the profit generated from the total revenue in a year. Net profit is the profit after tax. It measures the percentage of each dollar of revenue that a company converts to profit. The net profit is the bottom line of the income statement of the organization.
Return on Assets
This is the profitability ratio that measures the profitability of a company against its total assets. It is the ratio of the profit that a company generated and the assets used to generate that profit. The higher the return on assets, the higher the efficiency of the company in utilizing its resources. However, the assets are the control of the resources by a company as a result of a past event from which future economic benefits will flow into the entity. It is calculated by dividing profit after tax (PAT) by the total assets of the company.
Return on equity (ROE)
This also measures the financial performance of a company. It measures the profit generated by an organization as a percentage of shareholders’ equity. So, it measures the ability of the business to covert equity investment into profit. It also shows the ability of the company in utilizing equity for the growth of the company. It is calculated by dividing profit after tax by the shareholders’ equity.
In conclusion, different stakeholders like employees, investors, creditors, government, and others are interested in the profitability of a company. However, measuring the profitability of your business will show the financial performance of the business. Therefore, the measurement of the profitability of your business is very important.
Afeez is one of the founding partners of Marasas Consulting limited. He consults for both individuals and entities in the area of accounting, management, audit, tax, and investment. He has a wide range of experience both online and offline which allows him to provide relevant and timely professional advice and assistance to business owners with their accounting, tax, management, audit, and investment plans.
Afeez is a member of the Institute of Chartered Accountants of Nigeria (ICAN) and a member of the Nigerian Institute of Management (Chartered). He is a certified Google analyst and strategist. He earned his Bachelor degree in Management and Accounting from Obafemi Awolowo University, Ile-Ife, Nigeria, and earned an ordinary national diploma in Accountancy from The Polytechnic of Ibadan, Oyo State, Nigeria. He earned certification in “Excel Crash Course” and “Reading of Financial Statement” from Corporate Finance Institute, Canada.
Afeez is dedicated to helping clients achieve business success by helping them to establish solid and sound accounting, tax, and financial processes.