The 3 Profit Margins in Financial Ratio Analysis

The following three financial profit ratios can be easily tracked and measured by using your income statement or profit and loss statement. While the content of any P&L statement might be different from one business to another, the layout of any P&L report follows the same logic. The top of the statement includes the revenue or sales and the cost of goods sold (COGS) which gives the gross margin. Next the business operating expenses are reported and the total is deducted from the gross profit margin which shows the operating margin. Finally, any additional costs of business are added and the taxes which leaves the net profit margin at the bottom of the report.

The three simple formulas for calculating the profitability ratios out of your income statement figures:

1. Gross profit margin = Total revenue – Refunds and Allowances – COGS

2. Operating profit margin = Gross profit – Business operating costs

3. Net profit margin = Operating profit – Taxes and any additional costs

Are your profit margins good? What is a good net profit margin?

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There is no one specific answer to what is a good gross, operating or net profit ratio percentage. The reason is that the cost structure and the business models are different in different industries. For example, retail business has lower gross margins compared to manufacturing companies. In addition, even within the same industry or sector companies compete by using differentiated business strategies and models so one organization can have lower gross level margin while achieving a higher than average net profit compared to its industry.

Another important issue in profitability reporting and analytics is the horizontal analysis trend and the pursuit of continuous improvement. So a nice and effective way to track and monitor your profitability performance ratios is to measure the trend in profit from one period to another. Depending on the business the time period will vary from daily and weekly trends to monthly, quarterly and annual trend monitoring.

While most KPIs are industry specific and even company specific the profitability ratios are part of any management dashboard report. Each and every company measures and tracks its profitability performances which is the bottom line for any for-profit organization.

The advantages of using financial ratios and expressing them in percentages in addition to the actual figures are that you can compare your company ratios with your competitors, other industry members and even against organizations outside of your industry for functional benchmarks. The very basic and the simplest layout/form of your P&L statement should include one column with the actual numbers and one column calculating the percentage of sales for each record.

Finally by measuring your financial ratios – in this case the profit margins, you are able to perform break-even analysis. Why is break-even analysis important?

First of all, it allows you to determine the break even point – the volume of business or quantity where your total revenue equals to your total cost. In other words it tells you how many products or services must be sold in a given period in order to cover the total costs of business.

Second, by being able to develop your own break-even analysis you can perform various what-if scenarios and see how your current business model or any potential business model and cost structure will behave at various volumes of business activities.

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