Why should you understand profitability ratio? It'll help you determine your company’s financial standing. Most important, it illustrates how you're improving financially. Most small business owners only worry about their earnings when looking at financial statements. On the surface, a positive net profit may sound good; however, it doesn’t tell the whole story.

Use this Analogy If Phil spent $100,000 on products he sold for $101,000, you’d say he made a decent thousand dollar profit. Now, let’s say Andrew spent $5 on a product he sold for $1005. Who came out better considering both made the same? If you guessed Andrew, you’d be right. He used his money more efficiently.

It’s vital that you know the profitability ratio of your company. To determine it, use these four ratios:

Net Profit / Net Sales

Gross Profit / Net Sales

Net Profit / Assets

Net Profit / Investment

Net Profit Margin: Net Profit / Net Sales The net profit margin measures your company’s overall profitability. This margin is usually between 5-25%. It’s calculated after taxes and interest (If instead you include those two, you’ll have your company’s “Operating Profit Margin”).

Gross Profit Margin: Gross Profit / Net Sales The gross profit margin measures your company’s efficiency in producing goods. Remember, gross profit (i.e. Net Sales – Cost of Goods Sold) considers only variable costs—not fixed. You can improve your ratio by reducing inventory costs (e.g. buying in bulk, eliminate high inventory, etc.), or speeding up employee productivity.

Return on Assets (ROA): Net Profit / Assets Your return on assets measures your company’s use of resources. You can improve this profitability ratio by eliminating unneeded equipment. Sell your extra chairs. Rent cheaper, if possible. Spend more wisely on equipment purchases.

Return on Investment (ROI): Net Profit / Investment Your return on Equity measures your company’s use of invested dollars. You can improve this profitability ratio by following a similar approach on improving your ROA. Good company ROIs range from 20-35%. If it’s negative, you’re in trouble.

It’s essential that you use these four ratios in combination. Don’t leave one out. Look to improve your profitability ratio constantly. Analyze it month-by-month. See where you could improve. Understanding this will greatly improve your small business.

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