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Ask About Business Ratios -- Part Three

by Ratio Rookie | May 20, 2012

Subject :Finances

Dear Toolkit,

I've heard that calculating "business ratios" from my financial statements would be helpful in running my store. What I haven't heard is why. Can you enlighten me?


Ratio Rookie

Dear Ratio Rookie,

As we described earlier in this series, there are four major groups of statistics that are most commonly used to track business ratios. These four categories are (1) liquidity ratios, which we covered in Part One, (2) efficiency ratios, discussed in Part Two, (3) profitability ratios, and (4) solvency ratios.

Today, we'll tackle Profitability Ratios, beginning with the ever-popular gross profit margin ratio (sales less cost of good sold divided by sales), which indicates the percentage of sales dollars available to pay your operating costs—those costs over and above the cost of goods sold.

The net profit margin (net profit divided by sales) is the measure of how much after-tax profit (also known as net income) is generated from each dollar of sales. This is a key ratio as it tells you how much you can (or cannot) afford to pay yourself. This is the famous "bottom line."

In between gross and net profit margin is a ratio you might think would be called just plain old profit margin, but it's almost always referred to as return on sales! This ratio (profit before tax divided by sales) shows how much before-tax profit is generated from sales.

And then, just to confuse things further, we have a thing called operating profit margin, which is simply the percent of profit from "operations," meaning income before interest and taxes divided by sales.

Return on assets is a little trickier to compute and can sometime mislead you if you fail to take into account any seasonal variations. Another pitfall of this ratio is a kind of "quality of assets" issue. For example, if some of your assets are leased, the ROI might give you a deceptively high rate of return, while, in truth, leased assets almost always cost more over the lease period than if you owned the asset outright.

Return on equity, sometimes called ROI or return on investment, determines the "rate of return" your investment in the business is yielding in exchange for the risk you take just being in business. (If this ratio doesn't compare favorably to the rate of return you could earn on a CD or stocks and bonds, it might be a clue that a career adjustment is in order.) Bankers love to chew on ROIs, so just be aware of how yours is derived before you go in for a loan.

Earnings per share is also a type of profitability ratio, although this one is most generally expressed for large, publicly traded companies.

Practice figuring your profitability ratios and don't forget to review your liquidity ratios and efficiency ratios—and Part Four's rollicking discussion of those scintillating solvency ratios!