Profitability Ratios

Next, we approach the profitability ratios. These matter because it’s not enough to just look at our revenue as a company, we need to also analyze our expenses as a company, because revenue minus expenses is our profit.

We have two ratios for profitability:

• Profit Margin

• Gross Profit Margin

The profit margin attempts to answer, “For every $1 of net sales, how much do we keep in net income?” In other words, “What percentage of our revenue is expenses?”

Earlier, we said that our revenue was $102,000. Now let’s say that our net income is $5,100, therefore, our profit margin would be 5%. That means that out of everything that we sell, 5% of that becomes net income. In other words, 95% of our revenue is covered by expenses. 

The next profitability ratio is called the gross profit margin. Here we’re not asking about our net income, we’re asking about our gross profit. This ratio asks, “For every $1 of sales, how much becomes gross profit?”

If we remember the basic structure of an income statement, we have revenue minus the cost of goods sold, which equals gross profit.

In our example, our sales were $102,000. Our cost of goods sold was $30,600, meaning that our gross profit was $71,400 ($102,000-$30,600). Our gross profit margin then is $71,400 divided by $102,000, which is 70%, meaning that we keep 70% of our revenue as gross profit. In other words, our cost of goods sold expense is 30% of our revenue.

Now we know that our gross profit margin is 70% and our profit margin is 5%. What does that mean? That means that 65% of our revenue is to pay for our general and administrative

expenses.