Many Chicago businesses faced significant disruption when the COVID pandemic made its way to the shores of the Windy City. Not only did government orders create a challenge, but so did the concern about virus transmission. The whole experience not only impacted shopping and purchasing behavior, but has also had a lasting impact on the global supply chain. As a result, manufacturers could not properly forecast the resurgent demand for raw materials, supplies, and other inputs, post pandemic. The result has been a sharp increase in the cost of essential items. As Illinois businesses get back to normal, there are new challenges on the road to profitability.
While issues vary by industry, it is certain that companies should regularly evaluate performance to identify strengths, weaknesses, and where improvements can be made. One important method for making such an evaluation is with financial statement ratios. These ratios can quickly provide insight on how a business is performing. There are several types of ratios, but the ones most often used are profitability ratios. To help clients, prospects, and others, Selden Fox has provided a brief overview of profitability ratios and a few of the more commonly used ratios.
What are Profitability Ratios?
Profitability ratios are financial statement ratios used to understand the ability of a company to generate income over a set period relative to revenue, operating costs, and balance sheet assets. These ratios provide the best insight when compared to either prior periods, or other companies within the same industry.
Common Profitability Ratios
Gross Profit Margin
This ratio evaluates gross profit against sales revenue. To calculate gross profit margin, subtract total revenues from the cost of goods sold and then divide it by total revenues. The result reflects how much revenue a business has generated as compared to costs incurred. A higher margin indicates more production efficiency whereas a lower margin reflects lower production efficiency. There are many variables which impact margin such an increased cost, adverse purchasing policies, or low selling prices. To increase margin, management may consider increasing prices, elevating the sales volume, or seeking ways to reduce overall costs.
Operating Profit Margin
This ratio evaluates earnings as a percentage of sales before interest expenses and income tax are deducted. To calculate operating profit margin, divide operating profit by total revenues. The result identifies how well a business is managing its operating expenses. The operating margin is commonly used to evaluate management effectiveness since productive policies can help to manage, or reduce, overall operating costs.
Net Profit Margin
Also known as the bottom line, the net profit margin ratio provides insight into overall profitability once all expenses have been deducted. To calculate net profit margin, divide net profit by total revenues. This is a popular measure of profitability because it takes all expenses into account. However, this means one-time issues that may cause fluctuations in expenses or gains, are included in the calculation. Unfortunately, this can make it more difficult to accurately compare against prior periods or with competitors.
Return on Assets
This ratio measures the ability of an enterprise to generate profit by using available assets. To calculate return on assets, divide net profit by average total assets. A high number generally means a business is very efficient in using assets to generate profit, while a lower number indicates the converse.
Ratios are used to compare performance with competitors and industry averages, attract investors, and help identify areas in a business that may need work or attention. They can also be used to identify positive and negative trends that may help management make operational decisions.
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There are many types of financial statement ratios of which profitability ratios are one. Other ratios evaluate different aspects of performance including liquidity, leverage, and efficiency. These ratios are invaluable tools for Chicago businesses looking to evaluate performance on an on-going basis. If you have questions about the information outlined above or need assistance with an accounting or tax issue, Selden Fox can help. For additional information call 630.954.1400 or click here to contact us. We look forward to speaking with you soon.
