Since profit margins vary across industries, it’s essential to compare your gross profit ratio to similar businesses or industry norms. If you’re making a smaller margin than your competitors, then it’s time to check whether you’re pricing your products too low or if your production costs are too high. 
 

Measuring your overall gross margin is just the beginning—you can track the gross profit ratio for specific products and even individual customers. By doing this, you can be more targeted in your approach to raise performance and profitability.

Margins and pricing decisions

Analyzing your gross margins regularly brings an important benefit: it forces you to think beyond sales volume and market share. While it might be tempting to price your products lower than competitors to drive sales, you could end up losing money if your margin isn’t sufficient to cover your costs. It puts the focus back on how much you’ll need to sell your products for in order to break even or achieve your profit target. 

Your operating margin compares operating profit as a percentage of sales. Operating profit is your gross profit minus selling and administrative expenses such as rent, depreciation, salaries, marketing and utilities.

Continuing with our previous example, if your business has sales and administrative costs of $5,000 and $50,000 in sales, then its operating profit margin ratio is 100 x ($5,000 / $50,000), or 10%.

Analyzing your gross margin and operating margin together can tell you how well you’re managing operating expenses. For example, if your gross margin is high but your operating margin is low relative to industry benchmarks, then your operational costs maybe too high and you should consider ways to decrease fixed expenses.

 

Net profit margin ratio

Your net margin on the other hand, measures net profit—or your bottom line— as a percentage of sales. Net profit is your operating profit minus interest and tax. Again, following our example, if your interest and tax expenses add up to $1,000, then your net margin ratio is 100 x ($4,000 / $50,000), or 8%.

A strong net margin is an indicator of good management of overall expenses. A weak margin could signal potential problems with future debt repayments for businesses that are highly leveraged.

If you have a good operating profit margin but a slim net margin it is likely that a post-sales expense is to blame. This could include taxes or interest rates. That might be a sign to look at refinancing in an effort to lower your interest rates, or review how your tax structure is set up.

Another way to assess profitability is to look at how efficiently business resources are being used to earn profits. Return on assets, or ROA, compares your net income to the value of assets you own. If the value of your assets is $50,000 and your net income is $4,000 as above, then your return on assets is 100 x ($4,000 / $50,000), which is 8%.

The higher your ROA, the more efficient you are at turning a profit from your assets.

Again, it’s important to refer to industry norms when considering whether your ROA is competitive. You can also measure these by each piece of equipment, each department, or each location if you have more than one. This will allow you to identify which machinery is performing best. In the case of multiple business locations it can help isolate where your focus should lie. It can also help you identify and course-correct a department that is underperforming.

 

Return on equity

The last profitability ratio we’ll look at is return on equity (ROE). ROE measures the profits made on each dollar of equity investment. It’s a key measure for business owners and shareholders because it reveals how much they could potentially get back for their investment once debt repayments and business reinvestments are accounted for.

If you’re a sole investor with $60,000 invested in a business, then applying the net income from our example would lead to an ROE of 100 x ($4,000 / $60,000), which is 6.67%. It’s important to assess ROE over time and against businesses in the same sector. A high ROE is often associated with good business decisions and sound management of equity capital. However, having excessive debt could also lead to a high ROE, which is why this ratio should be examined in the context of other information on the balance sheet and income statement. For more information, check out these business calculators. 

Monitoring financial ratios regularly is crucial to maintaining your business’s financial health. When you know what is working well in your business — and what isn’t — you can implement the right strategies to drive better results. It’s also worth keeping an eye on key ratios if you want to grow your business, as potential investors and lenders often use them to decide if they’ll finance your future growth plans.

If you need a hand with calculating or interpreting the ratios discussed in this article, reach out to one of our bankers or schedule an appointment. We can put you in touch with professionals who can evaluate your financial ratios and put them in context to give you a clear view of what’s going on inside your business.

Schedule an Appointment