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Profitability Ratios

Ratios?

 You may have heard the term 'profit margins' or simply 'margins' discussed by people in business. It refers to the percentage of the total value of sales that represents the profit of the business. Managers want to know how much profit they are making as a proportion of sales revenue. The higher the proportion, the more profitable they are.

Gross Profit Margin

The Gross Profit Margin is expressed as a percentage of sales. It can also be written as a ratio (Gross Profit : Sales). The higher the percentage, the greater the proportion of sales going to profit as opposed to cost of sales.

For our example, the calculation is:

For every pound coming into the business from selling the product, over 73 pence was going into gross profit and around 27% was going into direct production costs.

Net Profit Margin

The Net Profit Margin is also expressed as a percentage of sales. Again, the higher the percentage, the more profitable the business. We expect the Net Profit Margin to be lower than the gross profit margin because it includes more costs.

For our example, the calculation is:

You can see that the answer is negative - the business was making a loss. In this case, for every pound coming in from sales, the business was paying out £1.09 in costs (direct and indirect). Not a great position to be in.

Comparisons

The advantage of the profitability ratios is that you can use them for comparison. Has the net profit margin improved from last year's figure? Is it higher than the net profit margin of their closest competitor.

Ratios give us a tool that we can quickly use to judge the performance of the business. In our example, we can see that overhead expenses are turning a gross profit into a net loss.
 
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What is Profit? | Gross Profit | Net Profit | Ratios | Challenges