One way of assessing sustainability is the calculation of ratios that capture the profitability indicators or efficiency indicators that businesses must review at regular intervals, which are:
- The gross profit margin ratio
- Operating Profit Margin Ratio
- The Net profit ratio
The three metrics come from the entity’s income statement.
- Gross profit = net sales minus cost of goods sold (Net sales = gross sales minus any returns and discounts)
- Operating profit = Gross profit less administrative and selling expenses (Administrative expenses = salaries, payroll taxes, benefits, rent, utilities, office supplies, insurance, depreciation, etc.)
- Operating profit includes all expenses except income taxes. Net Profits = Operating profits (plus any other income) minus any additional charges and minus taxes
Gross profit is the difference between sales and cost of goods sold.
Operating profit is the difference between sales and cost of goods sold plus selling and administrative expenses.
Net profit is the difference between net sales and all expenses, including income taxes.
Dividing each item by net sales and expressing the result as a percentage yields the viability rate.
Owners and managers should carefully monitor the three most important profitability ratios: Gross profit, operating profit and net profit.
An effective means of utilizing common size ratios as a management tool is to prepare them regularly, preferably at least quarterly with monthly calculation providing the best results.
It would be a good idea to calculate common size ratios for your company and consider which ones you think are most important. What items in your account statement are most critical to you or of greatest concern? Also, how do your company’s ratios compare to others in the same industry?
The calculation process of profitability ratios allows any company to adopt correct strategic decisions regarding sales, marketing, and cash flow control. It also defends the possibility of locating and acquiring investment funds, positively influencing the course of the company, the sector, and the economy in general.
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