Welcome to the 3rd Chapter! With an understanding of where to find the numbers on financial statements, it is time to analyze them. The most popular business question is, “How profitable are we?” Let's start there. We employ Profitability Ratios to ascertain this.
To illustrate, Company A and Company B both made $10,000 in Net Profit last year. Have they achieved similar success?
What would you say if I told you Company A had to sell $100,000 worth of goods to make that profit, while Company B needed only to sell $50,000? Company B is way more efficient. To measure this effectiveness, we will utilize margins. A margin indicates the profit retained in cents for every dollar of sales generated.
This calculates how cost-effectively you create your main product before spending on rents, salaries, or any marketing. It compares your Gross Profit (Revenue less the direct cost to produce the product) to your Revenue.
\( \text{Gross Profit Margin} = \frac{\text{Gross Profit}}{\text{Revenue}} \times 100 \text{%} \)When your Gross Profit Margin is 60%, for every dollar of sales, it costs you 40 cents to make the product. Then you have 60 cents left over to run the rest of the business.
It's the most comprehensive measure of overall efficiency. It examines the remaining amount after the settlement of all expenses, such as taxes and interest.
\( \text{Net Profit Margin} = \frac{\text{Net Income}}{\text{Revenue}} \times 100 \text{%} \)If the Net Profit Margin of a supermarket is 2%, they are playing a high-volume game - they have to sell a huge number of groceries as they are only keeping 2 cents on the dollar! A software company, however, might have a Net Profit Margin of 25%.
Ratios serve as an equalizer. It helps you compare a small local coffee shop with a large global brand, such as Starbucks, on equal footing by using percentages and not raw dollars. Let's test the math's on your margin!