For start-ups and businesses operating at a smaller scale, profitability is something to be inspired for, a lot to strive on. But profitability in itself seldom carries much weightage because there are other crucial parameters to profits as well.
Here are a few criteria that you can use to measure the profitability of your business.
1.Check Your Gross Profit
Gross profit is probably the simplest form of profit. Do not be surprised to know it is not the most widely used and reliable method of checking profitability. However, it can still tell you many things, and it is very much a stepping stone to other elements.
The Gross Profit Formula looks something like this.
Gross Profit = Net Sales Revenue – Cost of Goods Sold
What is net sales revenue? In business operations, you might realize that all sales are often not final because people return goods to exchange or unfulfilled quality benchmarks, and so on. Net sales revenue means your sales revenue, minus the sales price of such returns.
Secondly, the cost of goods sold requires a shift in perspective. What we’re looking at here? The goods sold, what is the cost and expenses for making them. Not only distributing, just bringing the raw material in and making the goods. These include costs like the purchase of raw materials, any previous inventory of raw materials, freights to get raw materials, etc.
And from this sum, the cost of goods that we returned is deducted, as it isn’t an expenditure anymore.
Gross profit shows the general profitability in making goods but does not include their distribution cost, which is really like looking at profits eyed closed.
2.Keep a Track of Net Profits
Net profits, or profit before interests and taxes, show a much clearer picture of profitability because they account for operating expenses. The calculation is simple and derives from the formula of gross profit.
Net Profit Formula is as follows:
Net Profit = Gross Profit – Operating Expenses
Operating expenses include expenses to get the goods from the supplier to the customer. These include costs like rent, fuel, insurance, salaries, selling, and distribution costs.
However, net profits don’t account for interest to be paid on loans or tax payments. On a smaller scale, this can either be entirely irrelevant because of a lack of existence of these payments and smaller tax-brackets or very relevant if the capital investment itself is in the form of a loan.
These expenses usually tend to be stable, or stably increasing throughout the life cycle, with fewer distortions. But a better idea is to deduct these expenses as well and get Profit after Interest and Tax.
3.Analyze Operating Expenses
Here we enter the analytical part of this article. First, as discussed, operating expenses include various costs like rent, fuel, insurance, salaries, selling, and distribution costs.
Several times, businesses see an increase in their incoming revenue yet a decrease in profit margins. Unless the raw material or the cost of making the goods has increased somehow, the answer lies in operating expenses. Since this not only deals with expenses relating to the human element directly, it is also the place where risk is mitigated, where research and expansions get planned and often showed.
4.Calculate Profits per Client
A quick diversion, this is a rehash of something that Richard Koch wrote in his book ‘The 80/20 Principle’, and it is worth mentioning when we discuss profitability actions.
You’ll notice a concentration in terms of revenue generation from your clients, which means more often than not, it is 20% of your clients that provide you with 80% of your business. These are clients with huge order quantities and often specific demands. The rest of 80% of your clients would amount to a meager 20% of your income with their small purchase amounts.
So, when you look at revenue per client, what you’re looking at is the profit generated per client, which is the difference between the costs incurred and the revenue generated per client.
However, if you’re quick to identify the needs and demands, anticipate their wants, and gather more such customers, you’ll notice a steady increase in your profit margins. Because your focus is on the clientele that is helping your business run, by people who like and order your product/service, and there is little hint of brand loyalty.
5.Price-to-Earnings Ratio
You might have heard this term associated with big companies in the stock market, and since we’re talking about businesses on a small scale that is not even listed, it does seem out of context. The price-to-earnings ratio calculates the ratio between the market price of share and earnings.
P/E Ratio Formula is as follows:
P/E Ratio Formula = Market value per share/ Earnings per share
Here you keep the price as the numerator and the earnings per share as a denominator. P/E ratio gives in-depth insights on a company’s performance.
The Bottom Line
The fact is that profitability should be according to the factors that encompass the needs of your business. So, are you ready to know if your company is profitable? Do keep these pointers in mind and learn the true worth of your company.
