Metrics to Help You Understand Profitability

Metrics are wonderful tools for any business owner because they allow you to compare numbers and percentages in an “apple to apple” fashion so that you can immediately tell if you are meeting your goal or improving from a prior period.

For example, knowing that your Gross Margin % for February was 8% does not mean much unless you can compare it to another period or to your goal. If you knew that January’s Gross Margin % was 6%, you know immediately that you beat January by 2%.

Below are four metrics that are useful to helping you understand profitability.

Gross Profit Margin Ratio

The Gross Profit Margin Ratio is a way for you to measure and track your profitability on sales and the related cost of sales. The formula is simply:

Gross Profit / Net Sales = Gross Profit Margin Ratio

Let’s say that XYZ Company, in 2017, made $500,000 in Net Sales. The COGS (Cost of Goods Sold) for the company was $300,000. This means that the Gross Profit for 2017 was $200,000. Using our formula we can find the Gross Profit Margin:

$200,000 / $500,000 = 40%

We know that the XYZ Company had a 40% gross profit in 2016. Let’s say that in 2016 the company made Net Sales of $550,000 but had a Gross Profit of 35%. Even though sales may have been higher the company can accurately compare the two metrics and determine that they actually profited more in 2017. If the company just compared sales dollars, instead of this metric, it would inaccurately assume that 2016 was better because sales were higher. You could also use this ratio on an individual product or category basis to find the profitability between various products.

Net Profit Margin Ratio

This ratio is very similar to the Gross Profit Margin Ratio; however, this ratio uses Net Profit instead of Gross Profit thus accounting for all of the company’s expenses. This ratio is a way for you to track how effective a company is at converting sales into profit. If a company made $800,000 but spent $790,000 in total expenses then the company is not effective at all at converting sales into profit.

The formula for this ratio is:

Net Profit / Net Sales = Net Profit Margin Ratio.

For the XYZ Company, in 2016, the Net Sales were $500,000. The total expenses for the entire company were $400,000. This means that the Net Profit for 2016 was $100,000. Using our formula we can find the Net Profit Margin:

$100,000 / $500,000 = 20%

We now know that the Net Profit Margin for the company in 2016 was 20%. The higher the Net Profit Margin ratio the more effective the company is in converting its sales into profits.

Profitability Index Ratio

The Profitability Index ratio helps with a company’s decision on making large purchases, usually capital expenses, by estimating how much, or little, profit will be made by the purchase.

The formula for this ratio is:

(Present Value of Future Cash Flow) / (Initial Value of Investment) = Profitability Index

Let’s say that a trucking company wants to upgrade its fleet but wants to know if the additional upgrades will yield a profit. It will cost $300,000 for the upgrade. It also knows that it will generate cash flow of $400,000 (in present value). Using our formula we can find the Profitability Index:

$400,000 / $300,000 = 1.33

Any number above 1 will indicate that the purchase will yield a profit. If deciding between multiple options, you would be able to compare the two Profitability Indexes to see which one would offer a better return.

Economic Value Added Ratio

The purpose of the Economic Value Added Ratio is to help you decide if investing cash in a capital expense outweighs any financial benefits of investing that same cash elsewhere. If, for example, a company made a capital purchase of $60,000, would that money have yielded a greater return if it was invested instead of spent on the capital purchase?

The formula for this ratio is:

(Net Operating Profits after Taxes) - [(Capital Invested) x (Cost of Capital)] = Economic Value Added

As an example, the XYZ Company’s Net Operating Profits after Taxes were $20,000. The company made a large capital purchase of $60,000. The company also determined that the money could have yielded a return of 10% if invested. Using our formula we can find out if it made financial sense to have made the purchase:

($20,000) - [($60,000) x (10%)] = $14,000

We know now that the Economic Value Added was $14,000. This means that although the company did not invest the money it still yielded a greater return by making the large capital purchase.

The Economic Value Added just means that this is what the purchase yielded if you subtract out the opportunity cost (the amount you could have received if you invested the money).

Let’s say the company instead made a large capital purchase of $250,000:

($20,000) - [($250,000) x (10%)] = -$5,000

In this case, the company would have been better off investing the money elsewhere and not making the capital expense.