How To Evaluate The Profitability Of The Business

Tracking and measuring your business profitability is one of the ultimate ways to grow your small business.

Plans to measure, evaluate, and analyze should be implemented into a business strategy from the start. And at every stage, businessmen need to think about measurability. The first step? Learn how to evaluate ongoing profitability.

How Does Profit Differ From Profitability?

 Before we start digging deeper into key profitability indicators, we should know some core terms. In spite of the fact that they sound similar, they differ from each other.

Profit is a term that often describes the situation when the revenue exceeds spending. For instance, a bartender at the bar spends one quarter to create one cocktail. They then sell the drink for $2.00. Their profit on one cocktail amounts to $1.75.

Profitability is closely related to profit - but with ONE key difference. It measures how successful your business is. It is an abstract number that measures a company’s profits.

How To Measure Your Profitability

Having a basic understanding of the difference between the two, we can move forward and look at three ways to measure your business success.

#1. Calculate Your Profit Margin Ratios

Tracking your profitability ratios allows you to monitor the health of your company and make better decisions in the future. Common profitability ratios include:

●  Gross Profit Ratio measures the performance of a business by dividing its gross profit figure by the revenue from operations.

Gross Profit Ratio = Gross Profit/Revenue from Operations

●  Operating Ratio shows you how well the company's operations contribute to its profitability.

Operating Ratio = Operating cost/Revenue from Operations

●  Operating Profit Ratio tells you how much profit a company makes after all the variables or operating costs have been paid.

Operating Profit Ratio = Operating Profit/Revenue from Operations

●  Net Profit Margin shows how much revenue or how much net earnings are generated from every one dollar in sales. The profit margin is arrived at through divided net income by total revenue, expressed as a percentage.

Net Profit Ratio = (Net Income/Total Revenue) x 100

Look at the example of how to determine net profit ratio:

The company Evolve, a car rental service, currently shows revenues in the amount of $50,000. The revenue that it generates is $29,000. Firstly, we need to determine net income:

$50,000 – $29,000 = $21,000 net profit

Then, to calculate the gross profit margin, you will divide net profit by total revenue:

$21,000 ÷ $50,000 = 0.42

Finally, you will multiply your gross profit by 100 to determine your net profit margin percentage:

0.42 x 100 = 42% net profit margin

This means that Evolve currently has a net profit margin of 42%.

●  Return On Investment

A calculation of the monetary value of an investment versus its cost. The formula of ROI is:

Return on Investment = (profit minus cost)/cost

#2. Check Your Profit Margin Per Customer

Not all customers are created equal. Some of them may be more profitable than others. To evaluate the profitability of your business, it's important to know which of your customers is bringing in a hugely outsized portion of your total revenue.

To calculate the profit margin per customer, take your net income per customer, which is what each customer spends minus the customer acquisition cost, then divide that number by your revenue from the customer over their lifetime with you. Multiply by 100 to get the percentage.

#3. Analyze Your Break-Even Point

Break-Even Point is the point at which Total Costs is exactly equal to Total Revenue. It helps every businessman establish the target needed to cover costs and make a profit. To calculate your break-even point, use the below formula:

Fixed Expenses + Variable Expenses = Break-Even Point

A break-even analysis helps to manage other aspects of your business - from deciding a price strategy to setting the budget to motivating sales staff.

Final Thoughts

If you're new at business, it can be daunting to manage the financial aspects of your company if you’re not good at it. However, by using some key formulas, you can have an understanding of how profitable your business is. Building a strategy is key to the success of your company.