Calculating Profitability
I. Gross Profit Margin
Your gross profit margin can be calculated with the following formula, using figures taken from your income statement.
Gross Profit / Sales
Recall that gross profit is the amount of sales dollars remaining after the cost of goods sold has been deducted.
If your gross profit margin is declining over time, it may mean that your inventory management needs to be improved, or that your selling prices are not rising as fast as the costs of the goods you sell. If you are a manufacturer, it may mean that your costs of production are rising faster than your prices, and adjustments on either side (or both) are necessary.
II. Net Profit Margin
Your net profit margin shows you the bottom line: how much of each sales dollar is ultimately available for you, the owner, to draw out of the business or to receive as dividends. It's probably the figure you are most accustomed to looking at. This ratio takes into account all your expenses, including income taxes and interest.
Example: If your net income is $500,000 and sales are $2,000,000, your profit margin is 25 percent (500,000/2,000,000 = .25; expressed as a percentage this is 25 percent)
Even if you meet your goal, you should always keep an eye on your profit margin. If it should decline, for example, it may indicate that you need to take a look at whether your costs are getting too high.
III. Operating Profit Percentage
The operating profit percentage can be calculated using the following formula, with figures taken from your income statement.
Operating Income / Sales
This ratio is designed to give you an accurate idea of how much money you're making on your primary business operations. It shows the percentage of each sales dollar remaining after all normal costs of operations. By looking at this ratio over time, you can get a fix on whether your overall costs are trending up or down.
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