For Part Two of our small business finance ratios, we will focus more on the operating ratios that are beneficial to managers and decision makers. Operating ratios are data points that use information from the profit and loss statement to see impacts of various costs and what profit truly means. With that, let’s dive right in.
Gross Margin: ((Total Revenue – Cost of Goods Sold) / Total Revenue)
The gross margin provides you with the percentage of each dollar of revenue the company claims as gross profit. Gross profit is calculated by subtracting the total cost of goods sold from the total revenue. Gross profit is essentially what money the company has left to pay all other administrative expenses. Once you subtract cost of goods sold from total revenue, then divide that number by total revenue to arrive at the gross margin percentage.
For example, if total sales are $100, cost of goods sold is $50, the equation would be: ($100 – $50)/$100=0.5
This gives you a 50% profit margin. So for each dollar of revenue, 50 cents of that dollar cover the direct costs, leaving 50 cents on each dollar to cover other company expenses. This ratio gives you a quick look at the company’s ability to manage their direct costs. These ratio’s will vary depending on the industry, but the higher the gross margin the better. A higher margin means the company is able to deliver its product or service while allowing for portions of sales to contribute covering other expenses and can result in a higher profit margin.
Profit Margin: (Net Income / Total Revenue)
Having discussed gross margin, now let’s touch on the profit margin. A higher profit margin means the company is more profitable and has a strong handle on its cost structure.
For example, if a company has sales of $100 and a net income of $15 the equation would be: ($15/$100)= 0.15
This gives the company a profit margin of 15%. What this means that for every one dollar of revenue, after all cost of goods sold and administrative expenses are paid the company still has 15 cents that are available for whatever the company wishes to do with them. It is important to note that although net income may go up in total dollars, that does not necessarily result in a higher profit margin. This ratio is important to monitor so the company can keep tabs on its cost structure.
So now that you have some good metrics to use you can begin to track this data and see how your business is performing. By using all of the information in Part 1 and 2 you will be able to get a snapshot periodically and then manage accordingly depending on what the data is telling you. We always stress, see beyond the numbers. With these tools you can begin to do that.
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