Financial Analysis

Category 3: Profitability Ratios
These are ratios that you use to assess the profitability of your business.

They are some of the most important indicators of whether your business is financially successful or not. You and other investors in your business should be interested in these ratios because they will demonstrate the performance and the potential of your business.

The ratios are:

  1. Gross profit margin ratio.
  2. Net profit margin.
  3. Operating profit percentage.
  4. Materials to sales.
  5. Labour costs to sales.
  6. Overhead costs to sales.
  7. Return on assets.
  8. Return on investment.

1. Gross Profit Margin Ratio:

Gross profit is the amount of sales dollars, which are left after the direct cost of producing those sales, has been deducted. The gross profit margin ratio is the percentage of your sales left after subtracting the cost of sales. It measures the percentage of the sales dollars that are available to pay or contribute toward the overhead expenses of the business.

If your gross profit margin is declining it may mean that the management of your stocks needs to improve or that your selling prices are not rising as fast as they should. If you are a manufacturer, it may mean that the cost of production is growing faster than your prices and adjustments may be necessary.

2. Net Profit Margin:
Your net profit margin will show you what the bottom line is. It indicates how much of each sales dollar is ultimately available to you as the profit from your business. The ratio is the percentage of sales dollars left after subtracting the cost of producing those sales and all the other expenses of the business.

You should have a general idea of the range of profit you should be achieving in your business if it belongs to a particular industry. This is simply done by comparing your results with those of the industry standards. If you fail to meet your target, it could mean you have set yourself an unrealistic goal or it could mean you are doing something wrong and not achieving the profit you should.

3. Operating Profit Percentage:
The operating profit percentage is calculated using the following formula:

                Operating income ÷ sales

This ratio gives you an idea of how much money you are actually making on your main business operations. If your business receives income other than from its operation, then those figures are left out. The ratio shows a percentage of each sales dollar remaining after all the costs of the operations have been deducted. By monitoring this ratio over time you can get an idea of whether your overall costs are climbing or reducing, in relation to your sales.

4. Materials to Sales:
This ration shows how much of the sales dollar is taken up by the cost of your direct materials.

This ratio indicates how much of the sales dollar is consumed by the cost of direct materials.

5. Labour to Sales:
This ratio shows how much of your sales dollar is spent in paying for direct wages.

In this case 21.6 cents of every sale $1.00 will be spent on direct labour.

6. Overhead Expenses to Sales:
This ratio shows how much of your sales dollar is used for non-factory overhead expenses.

In this case 20.8 cents of every sales $1.00 will be used for non-factory overhead expenses.