While the Income Statement is excellent for seeing at a glance whether or not your business is profitable, a deeper analysis can reveal so much more, like how different business units or products are performing, or whether your seasonal business should be a full-year business. The good news: analysis doesn't require much more than 5th grade math skills. In this article, we will examine two ratios of profitability: Net Profit Margin and Gross Profit Margin.
Net Profit Margin
Net Income / Revenue This is how hard your business has to work to turn revenue into profit. Businesses like grocery stores are "low margin" meaning they are very expensive to operate. For every dollar they earn, they only get to keep one or two cents as profit. Net profit margin is a great tool to even our seasonality trends in revenue.
Example: Cindy's Gift Wrap does most of its business in the last quarter of the month. Cindy is trying to decide whether she should close her business for the year, and only open during the holiday season. Cindy made $80,000 in revenue last Q4 , but has to hire seasonal workers, rent extra space, and buy more supplies. Her 4th Quarter expenses are $50,000, giving her a Net Profit Margin of 37.50% = [80,000 - 50,000]/80,000.
Compared to her last 3rd quarter, Cindy only made $30,000, but she had much fewer expenses too, only $10,000. Cindy's Q3 Net Profit Margin was 66.67% = [30,000 - 10,000]/30,000. So Cindy is able to operate her non-seasonal business at a much higher margin than during the holidays. I would recommend to Cindy to try to expand her non-seasonal business through advertising or new offerings because she get s to keep more of the money she earns as profit. Also, I would recommend Cindy look to see if she can reduce any her 4th Quarter expenses perhaps review or processes and create some automation, so she can retain more of her revenue as profit.
Gross Profit Margin
Gross Profit / Revenue
Similar to the Net Profit Margin, Gross Profit Margin measures the amount of gross profit derived from selling goods. Commonly referred to as the "mark-up" The Gross Profit Margin allows you to see the ratio of how much you paid to acquire your goods and how much you are able to sell them for. This is an excellent metric to use if you have multiple products and want to compare performance.
Ray's Rare Gems sells two types of gems: Diamonds and Rubies. Ray is able to purchase diamonds for $2,000/ct and sell them for $5,000 per ct. The Gross Profit on the diamonds are 60% = [5,000 - 2,000]/5,000. Ray can purchase Rubies for $100/ct. and sell them for $200/ct. The Gross Profit on the rubies are 50% = [200 - 100]/200. Though they are much more expensive, Ray should invest more in his Diamond supply. Perhaps a small business line of credit could help him.
These are only two example of how comparing two numbers in your financial statements can give you deeper insight into your business. Look for future articles on Balance Sheet Analysis: Liquidity and Solvency, and Activity Ratios like Receivables Turn, Days of Sales Outstanding Ratio, and Working Capital Turn.