Measurement is the key to any successful business. To remain competitive in today's digital age, businesses need to measure their profitability. If you don't know where you stand, how can you improve? It's important to track your profit and other key financial indicators regularly so that you can make informed decisions about the future of your company.
There are many ways to measure your company's financial performance, but not all of them are created equal. This article will provide you with an overview of some key metrics and how they can help you keep tabs on your business' overall health and growth over time.
The net profit of a business is calculated by subtracting its operating expenses from its total revenue. For example, if your company generates $100,000 in revenue and has operating expenses of $50,000, then its net profit would be $50,000.
The use of this metric helps you measure the profitability of your company because it shows how much money is left over after all costs have been paid (i.e., it's what remains). If a business has positive net income--that is, there's more money available than was spent--then it's considered profitable; conversely, if there wasn't enough cash left over after paying bills and salaries to cover basic operating costs (let alone make any additional investments), then that organization may not be able to survive long term without making some changes or taking on new investors who can provide the necessary capital.
Gross profit is the total sales revenue for a company, minus the cost of goods sold (COGS). COGS are the direct input costs of everything you sell. Many businesses use this figure to determine their profitability because it's more reflective of actual sales than net income is. The gross profit percentage is calculated by dividing the total gross profit by the total revenue. The result is a percentage that can be used to compare one company's profitability against another's. For example, if a business has a gross profit of $100,000 and its total revenue for the year was $1 million, then its gross profit margin would be 10%.
The main difference between gross profit and net profit is that the former only takes into account the COGS while the latter takes all other business expenses into account, such as salaries, advertising and marketing expenses, equipment purchases, utilities, etc.
Return on assets (ROA)
Return on assets (ROA) is a measure of how much profit you generate for every dollar of assets. It tells you how well your business has been able to turn its resources into earnings, and it's calculated by dividing net income by total assets. You can think of ROA as the percentage of profits that comes from the capital invested in your business.
Return on equity (ROE)
Return on equity (ROE) is a measure of how well a business uses its shareholders' money. It's calculated by dividing net income by average shareholder equity, and it can be expressed as either a percentage or a decimal.
A high ROE means that your business is using its capital wisely, which may make it attractive to investors who want to buy into your company. A low ROE could indicate that your business isn't making good use of its assets or has too much debt on its books--or both! The average ROE for the S&P 500 (a stock market index tracking the stock performance of 500 large companies listed on stock exchanges) is 15%. A healthy ROE is generally considered to be above 20%.
Return on investment (ROI)
Return on investment (ROI) is the ratio of profit to investment. It measures how profitable an investment is, compared with what you had to put into it. If a business invests $1 and earns $1.50 in profit, its ROI is 50%. A healthy ROI for a business should be above 20%, although some industries have higher average returns than others.
In general, businesses with high operating margins (income after COGS and operating expenses divided by revenue) and high asset turnover (revenue divided by average total assets) will have higher ROIs.
This metric can be helpful when deciding whether or not to expand or hire more staff members because it tells you how efficiently your business is being at the moment.
Operating cash flow ratio
The operating cash flow ratio is another profitability ratio that compares a company’s operating cashflows (income after COGS and operating expenses) to its current obligations (debt and leases over the near term). It can be calculated by dividing operating income by current liabilities, expressing how many times cash from operations can cover near term expenses.
A figure lower than 1.0x reveals that a company needs outside capital to meet its obligations, given cash flow from operations are not adequately covering liabilities. A number higher than 1.0x signals the opposite - that a business is generating enough cash flow from operations to comfortably cover its near-term liabilities.
Operating cash flow ratios can be useful when comparing companies in different industries, as well. They reveal how much money people are actually making from the business itself -- which signals whether a business model is sustainable or needs optimization.
We hope this article has inspired you to take a look at the different ways your business could measure its profitability. It’s important that you find the method that works best for you and stick with it. This way you are always on top of your company's financial health at all times!
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