Do you want to achieve higher profitability for your business? Probably yes. However, the path to sustainable profitability has many different crosses. In most cases, some paths will require you to build yourself up before you achieve the desired profitability. Being profitable is not a destination. It’s a journey. You need to be creative, strategic and committed to excellence to achieve it.

What is Profitability?

Profitability is an indicator of your business’s financial health and success because it measures your company’s ability to generate sales income relative to its expenses. Simply, profitability refers to a business’s ability to make a profit and tell you and key stakeholders whether your company is able to keep its position in the market. In such a way, this measure provides a more accurate picture of your small business’s financial performance.

For example, if your company has a high net profit margin, it means that you are making more money than you are spending on operating costs. This is a good sign of profitability and indicates that your business is financially stable. If your costs are higher than your income, however, your net profit margin will be negative, which can be a warning sign of financial trouble.

On the other hand, a low net profit margin could indicate inefficiencies or high costs that are eating into your profits. This could be due to poor management decisions, excessive spending, or an unprofitable product or service.

As you can see, by closely analyzing metrics such as net profit margin, gross profit margin, and operating margin, businesses can gain insights into their ability to generate profits and sustain long-term success. These profitability measures are vital for business management, as they reflect a company’s ability to cover costs and generate more profit, contributing to a sustainable and profitable business model.

Profitability Ratios – How Can You Measure Profitability?

Every company that wants to survive needs to know at least three key profitability numbers: net profit margin, gross profit margin, and operating margin.

Simply, these metrics provide you with insights into a company’s financial performance and help identify areas for improvement.

Most common profitability ratios include net profit margin, gross profit margin, operating margin and return on equity, and return on assets.

Net Profit Margin

Net profit margin measures a company’s overall profitability, calculated by dividing net income by total revenue.

So, the net profit is the amount of money left over after all expenses have been deducted from revenue. This includes operating costs, taxes, and interest payments.

If your net profit is $20,000 generated from $100,000 total revenue earned, the net profit margin will be 20% (20,000/100,000 = 0,2, or 20% if you multiply this number with 100). This means that for every dollar of revenue, the company is earning 20 cents in profit.

A low net profit margin can indicate potential issues with cost management or pricing strategies. It can also mean that the company is facing fierce competition and struggling to maintain profitability.

Gross Profit Margin

Another important profitability ratio is gross profit margin, which shows what portion of sales income is left after meeting the costs of delivering services or creating products.

Gross margin calculates the percentage of revenue left after deducting the cost of goods sold (COGS). This ratio measures a company’s profitability before accounting for operating expenses and shows the percentage of revenue that is left after deducting the cost of goods sold.

For example, if your revenue is $100,000 and your COGS is $60,000, then your gross profit margin would be 40% ($40,000/$100,000). This means that for every dollar of sales, your company keeps $0.40 as gross profit.

A higher gross profit margin means your company generates more revenue and effectively controls its production costs.

Operating Margin

Operating margin is a measure of a company’s profitability from its core operations, calculated by dividing operating income or earnings by total revenue. In this case, operating income is earnings before interest and taxes (EBIT) that are calculated by subtracting operating expenses such as COGS, rent, equipment, inventory costs, sales and marketing, research and development, payroll, insurance, and other administrative costs from total revenue.

Related: Mastering Inventory Management: Everything You Need to Know

For example, if your operating income is $100,000 and your total revenue is $500,000, your operating margin would be 20% ($100,000 / $500,000 = 0.2 or 20%).

A higher operating margin indicates that the company is able to generate more profits from its sales and has better control over its expenses.

A low operating margin may indicate that a company is struggling to cover its operating expenses and may need to make changes in order to become more profitable.

Return on Equity and Return on Assets

Return on equity (ROE) is a profitability measure that is calculated by dividing net income by shareholders’ equity, while ROA is calculated by dividing net income by total assets. As you can see, it is a ratio that shows how much profit a company generates with the money invested by its shareholders.

Let’s say you, according to your income statement, you generate a net income of $10,000, and the average shareholders’ equity, according to your balance sheet, is $50,000. This would result in an ROE of 20%. This means that for every dollar invested by shareholders, the company generates 20 cents in profits. A higher ROE indicates a more efficient use of shareholder capital.

On the other hand, ROA measures how effectively a company uses its assets to generate profit. The formula you can use to calculate ROA is:

Continuing with the example above, if your company has $100,000 in total assets and a net income of $10,000, then your ROA would be 10%. This means that your company generates 10 cents in profit for every dollar invested in assets.

However, it is important to note that these ratios should not be looked at in isolation. Other factors, such as industry standards and economic conditions, should also be taken into consideration when interpreting these numbers.

Factors Affecting Profitability

From profitability ratios calculations, you can already see what impacts your profitability, and the most visible impactful elements are the costs your business generates and the pricing strategy you use.

However, there are also other factors, such as demand, competition, and market dynamics, that also play a significant role in your company’s profitability.

Still, there are more things, and my team and I, in the last several years, conducted research from data from more than 150 companies, where we found really interesting things when it comes to factors impacting profitability. The research is in the final stage, and I will share the results on entrepreneurship in a box. I will say that management is the most important factor (the most frequent factor according to qualitative research from the interviews). So, here, in large part, we think that productivity and efficiency are essential for maximizing profitability.

Let’s look at the factors we mentioned here.

Expenses and Cost Control

You can see from profitability ratios that your business expenses, such as labor, materials, and overhead costs, can impact your company’s profitability by reducing its net income.

So, you must implement effective cost control measures like budgeting and expense tracking in order to minimize unnecessary business expenses and improve your company’s financial performance.

You can improve your profitability by improvements inside your business processes to increase productivity and efficiency, which can lead to more profit.

Demand, Competition, and Market Dynamics

It is logical that a higher consumer demand often leads to increased revenue and net income, in such a way producing a higher profitability. However, competition from other businesses in the same industry can also affect your company’s profitability by reducing market share and forcing you to lower your prices.

Market dynamics, such as changes in consumer behavior and technological advancements, can further influence on how you generate profits. So, you must adapt to these changes if you want to maintain a higher profitability.

Productivity and Efficiency

If you focus on business management and invest in employee development and training, you can improve your business productivity, which will lead to more profit. Productivity, in simple terms, measures how much work you done in a specific period of time or spending less money for doing the same thing. So, logically, if your business is more productive, you will lower costs and produce more output for these lower business costs. In such a way, you will increase your future profitability.

So, you must ensure that you have efficient business processes, systems, and business activities because they will help you reduce waste and improve your net income. But remember, by increasing productivity without the same level of increased expenses, you can increase profits.

There are also other factors you must take into consideration that will impact how much profit your business makes. However, we will cover more of them when we publish the results of our research. For example, better customer experience or implementing recurring revenue can lead to higher profits.

Cash Flow and Profitability

Cash flow and profitability are closely related concepts but not the same when it comes to your business’s financial health.

Related: Finance Management: A Guide to Understand and Manage Cash Flow

For example, on paper, you can be profitable; however, with a negative cash flow statement, your company will not succeed. Let’s say you sell $100,000 of your products and services in a specific period of time, and you give 30 days for your customers to pay you. If you don’t have enough money in your bank account to finance your daily operations, you will be in problems.

So, while you are analyzing profitability, you must also use your cash flow statement to continuously monitor your business’s cash inflows and cash outflows.

Remember that with effective cash flow management, businesses can maintain profitability and ensure long-term success.