# How to Analyze Profitability

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1 How to Analyze Profitability Peoples Bank Business Resource Center Business Builder 7 peoplesbancorp.com

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3 Table of Contents What to Expect... 4 What You Should Know Before Getting Started... 4 Profitability Ratios... 5 Gross Profit Margin Ratio... 6 Operating Profit Margin Ratio...7 Net Profit Margin Ratio... 8 Other Common Size Ratios... 8 Break-Even Analysis...10 Break-Even Analysis for Sales Break-Even Analysis for Units Sold Calculating Return on Assets and Return on Investment...14 Return on Assets...14 Return on Investment...15 Checklist...16 Resources

5 This guide looks at several aspects of financial ratio analysis. In case your high school math is a bit rusty, a ratio is simply a comparison between two numbers. If a basketball team has won six games and lost three, its ratio of wins to losses is six to three, which is equivalent to a ratio of two to one. If another team has won eight games and lost four, it also has a win/loss ratio of two to one. In the business arena, the most commonly used kind of financial ratios are various comparisons of two numbers from a company s financial statements, such as the ratio of net income to annual sales. A ratio can be written in several different ways: 2:1 2-to-1 2/1 2 In these pages, when a ratio is in the text, it will be written out using the word to, as in two to one. If it is in a formula, the slash sign (/) will be used to indicate division, as in 2/1. PROFITABILITY RATIOS Here are the profitability ratios that small business owners should look at regularly: Gross Profit Margin Ratio. Operating Profit Margin Ratio. Net Profit Margin Ratio. Other Common Size Ratios Don t worry if some or even all of these terms are unfamiliar. We will define each of them as we go along, and will explain how you can best use them. The three measurements of profits gross profit, operating profit and net profit all come from your company s income statement. As a reminder, here is a definition of gross profit, operating profit and net profit. (As you will see, the definitions build on one another, reflecting the way net sales are affected by increasing expense components.) Gross profit = Net sales minus the costs of goods sold. (As a reminder Net sales = gross sales less any returns and discounts.) Operating profit = Gross profit minus selling and administrative expenses (Administrative expenses = salaries, payroll taxes, benefits, rent, utilities, office supplies, insurance, depreciation, etc.) Operating profit includes all expenses EXCEPT income taxes. Net Profit = Operating profit (plus any other income) minus any additional expenses and minus taxes. Net profit is what is known as the bottom line. 5

6 BUSINESS BUILDER 7 As you can see, each of these three terms is simply a way of expressing profit when different categories of expense are included. Gross profit is the difference between sales and the costs of goods sold. Operating profit is the difference between sales and the costs of goods sold PLUS selling and administrative expenses. And finally, net profit is the difference between net sales and ALL expenses, including income taxes. The three ways of expressing profit can each be used to construct what are known as profitability ratios. This is done by dividing each item into net sales and expressing the result as a percentage. For example, if your company had gross sales of \$1 million last year, and net profits were \$50,000, that s a ratio of 50,000/1,000,000 or 5%. There are several reasons that ratios are expressed as percentages. This makes it easy to compare your company s results at different time periods. It also allows you to compare your company s results with those of your peers or competitors, and with industry benchmark ratios (which will be discussed in more detail below.) It s easier to discuss these ratios using actual numbers, so we ve included the following income statement for the fictional Doobie Company. Look at line numbers 3, 9, and 14. We will use the Doobie Company s gross profit (line 3), operating Income (line 9) and net income (line 14) numbers to compute the three profitability ratios. Gross Profit Margin Ratio Doobie Company Income Statement for the period ending December 31, 20 Item 1. Sales \$ 200, Cost of goods sold \$ 130, Gross Profit \$ 70, Operating expenses 5. Selling expenses \$ 22, General expenses \$ 10, Administrative expenses \$ 4, Total operating expenses \$ 36, Operating income \$ 34, Other income \$ 2, Interest income \$ Income before taxes \$ 36, Income taxes \$ 1, Net profit \$ 34,200 Gross profit is what is left after the costs of goods sold have been subtracted from net sales. (Cost of goods sold, also called cost of sales, is the price paid by your company for the products it sold during the period you are looking at. It is the price of the goods, including inventory or raw materials and labor used in production, but it does not include selling or administrative expenses.) 6

7 The ratio of gross profit as a percentage of sales is an important indicator of your company s financial health. Without an adequate gross margin, a company will be unable to pay its operating and other expenses and build for the future. Here is the formula to compute the gross profit margin ratio: Gross profit margin ratio = (Gross profit/sales) x 100 (Multiplying by 100 converts the ratio into a percentage.) Let s use the income statement data for the fictitious Doobie Company and compute the gross margin ratio for the company: Doobie Company Gross Margin Ratio: \$70,000/200,000 = x 100 = 35% The gross profit margin ratio for the Doobie Company is 35%. Your company s gross margin is a very important measure of its profitability, because it looks at your company s major inflows and outflows of money: sales (money in) and the costs of goods sold (money out.) It is a real measure of profitability, because it must be high enough to cover costs and provide for profits. Because it is an important barometer, you should monitor it closely. In general, your company s gross profit margin ratio should be stable. It should not fluctuate much from one period to another, unless the industry your company is in is undergoing changes which affect the costs of goods sold or your pricing policies. The gross margin is likely to change whenever prices or costs change. Operating Profit Margin Ratio The operating profit margin is an indicator of your company s earning power from its current operations. This is the core source of your company s cash flow, and an increase in the operating profit margin from one period to the next is considered a sign of a healthy, growing company. (If your company s operating income is not sufficient to generate the cash you need to keep operating, you must find other sources of cash.) Here is the formula to compute the operating profit margin ratio: Operating Profit Margin = (Operating Income/Sales) x 100 7

8 BUSINESS BUILDER 7 Using the income statement data for the Doobie Company, we can compute the following operating profit margin: Doobie Company Operating Profit Margin Ratio: \$34,000/200,000 = x 100 = 17% The operating profit margin ratio for the Doobie Company is 17%. In general, the operating profit margin is an indicator of management skill and operating efficiency. It measures your company s ability to turn sales into pre-tax profits. It is a ratio that you can use to compare your company s competitive position to others in the same industry. Because it looks at a company s operating income before taxes are subtracted, the operating profit margin is sometimes considered a more objective evaluator than the net profit margin ratio. (However, as you will see, this is not true for the Doobie Company. Given the small amount paid in taxes, the gross profit margin and the net profit margin ratios are nearly identical.) Net Profit Margin Ratio The formula for the net profit margin ratio is as follows: Net Profit Margin Ratio = (Net Income/Sales) x 100 Doobie Company Net Profit Margin Ratio: \$34,200/200,000 = x 100 = 17% The net profit operating margin ratio is 17%. Now that you know how to calculate the gross profit margin ratio, the operating profit ratio, and the net profit margin ratio, and why they are used, take a break from reading this guide and calculate these ratios for your own company. Other Common Size Ratios While the calculation and evaluation of the gross profit margin ratio, the operating profit ratio, and the net profit margin ratio are important, there are many other helpful tools you can use to get real information from the data in your company s income statement. 8

12 BUSINESS BUILDER 7 Here is how the owners of the Doobie Company would calculate the break-even point for their business, using data taken from the income statement above. Their first step is to separate fixed costs from variable costs. The Doobie Company s only variable cost is the cost of goods sold. Selling, general, and administrative expenses are all fixed costs. (For your company, the data may not break out so evenly. Just divide fixed and variable costs to the best of your ability.) For the Doobie Company, the formula Sales at the break-even point = Fixed Expenses + (Variable Expenses expressed as a % of sales) translates into the following: Sales at the break-even point = 36, S (Fixed expense of 36,000 is calculated based on data from the Doobie Company s income statement: Selling expense = \$22,000, General expense = \$10,000, Administrative expense =\$4,000. These expenses total \$36,000.) Variable expense for the Doobie Company is the cost of goods sold as a percentage of sales. Looking at the Doobie Company common size income statement, we see that the cost of goods sold is \$130,000, or.65 of sales. Now we have to solve the equation S = 36, S where S stands for Sales at the break-even point. Move the.65s to the other side of the equal sign. (As you may remember from algebra class, it becomes a negative.65s when you move it to the other side of the equation.) So now we have, on one side of the equation, 1S minus.65s, as shown below: 1S -.65S = 36,000 or.35s = 36,000 Now we can easily solve for S (which here stands for Sales at the break-even point ) by dividing.35s into 36,000. S = \$102,857 The Doobie Company is at its break-even point when sales total \$102,857. The next dollar of sales will include some profit. Calculate the sales break-even point for your business. Using Break-Even Analysis for Profit Planning Now that we understand how to calculate the break-even point, we can make one small adjustment to the break-even analysis formula so we can do some what if planning about profitability. After all, you don t want to just know where you are today in terms of break-even. You almost certainly also want to know how to attain a given amount of profit. 12

13 You can easily calculate the amount of sales necessary for a desired amount of net income before taxes. We just revise the formula slightly by adding the amount of net income you want your company to earn, as follows: Sales at the break-even point = Fixed expenses + Variable expenses as a percentage of sales + Desired Net Income. Let s say the owners of the Doobie Company have a goal of, say, \$50,000 in net income before taxes, and want to know what level of sales will be required to generate that. They just make the following calculation: Sales at the break-even point = 36, S + 50,000 Using our handy high school algebra again, we solve the formula in these steps: S = 36, S + 50,000 S = 86, S 1S -.65S = 86,000.35S = 86,000 S = 245,714 The Doobie Company must generate sales of \$245,714 to produce a net income before taxes of \$50,000. Use break-even analysis to calculate a specified amount of net income for your business. Break-Even Analysis for Units Sold Depending on what kind of business you are in, it may be useful for you to calculate break-even in terms of the number of units sold as well by revenues. In other words, you want to know the number of units that must be sold to reach the break-even point. This can be calculated using this formula: Break-even for Units to be Sold = Fixed expenses divided by (Unit sales price minus Unit variable expenses) This formula needs two new bits of information: the unit sales price and the unit variable expense. 13

14 BUSINESS BUILDER 7 If you know the sales price for your company s products (for the Doobie Company it is \$20.00 per unit) you can compute the unit variable expense, using the variable expense as a percentage of sales; we developed that figure earlier in this guide. For the Doobie Company, the variable expense was.65. So the unit variable sales expense is \$20 multiplied by.65, which equals \$13. What this means is that each unit has a variable cost of \$13. Plugging the data into the formula, it looks like this: Break-even for units to be sold = Fixed expenses divided by (Unit sales price minus Unit variable expenses) Let S = Break-even for units to be sold S = 36,000/(20-13) S = 36,000/7 S = 5,142 The Doobie Company must sell 5,142 units to break even. If it sells only 5,141, it is not yet generating any profits. On the 5,143d unit it sells, part of the revenue from the sale of that unit will contribute to profits. If appropriate for your business, calculate the number of units that must be sold to reach the break-even point. CALCULATING RETURN ON ASSETS AND RETURN ON INVESTMENT The final two types of profitability analysis we will discuss in this manual are: Return on Assets and Return on Investment Return on Assets You use the return on assets ratio to measure the relationship between the profits your company generates and assets that are being used. You compute it using data from both the income statement and the balance sheet. 14

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MASTER BUDGET - EXAMPLE Sales IN UNITS for the previous two months (of last quarter), as well as the sales forecast for next quarter are as follows: Sales Budget Units May sales (ACTUAL) 20 June sales

### Having cash on hand is costly since you either have to raise money initially (for example, by borrowing from a bank) or, if you retain cash out of

1 Working capital refers to liquid funds used to purchase materials and pay workers. This is in contrast to long term capital such as buildings and machinery. Part of working capital management is cash