Running a Profitable Company

Overview

The bottom line. That’s what many business people look at to gauge the profitability of a company. While important, the bottom line doesn’t always provide the entire picture, and using it as the sole barometer of company performance could have serious fiscal repercussions.

This discussion provides some simple profitability ratios and analytical procedures that can help determine your company’s present and future financial standing. With your findings, you can identify company trends and compare current figures to your business’s historical performance. Once this essential data is in hand, you will be able to evaluate your business in relation to your competition and industry norms.

The following ratios and analytical procedures described here will provide you with a quick reference guide to how your business is performing:

For more information on financial ratios, see Financial Ratio Analysis.

Ratios

• Gross Profit on Net Sales
• Net Profit on Net Sales
• Management Rate of Return
• Net Profit to Tangible Net Worth
• Rate of Return on Common Stock Equity

Analytical Procedures

• Comparative Statements
• Index-Number Trend Series
• Common-Size Statements
• Analysis of Financial Statement Components

This discussion also provides you with a detailed example of a common-size income statement and other procedures you can use to examine your company’s profitability.

Outline:

I. Purpose of Profitability Analysis

A properly conducted profitability analysis provides invaluable evidence concerning the earnings potential of a company and the effectiveness of management.

II. Profitability Ratios

Profitability ratios are the most significant — and telling — of financial ratios. Similar to income ratios, profitability ratios provide a definitive evaluation of the overall effectiveness of management based on the returns generated on sales and investment.

The adequacy of your company’s earnings can be measured in terms of (1) the rate earned on sales; (2) the rate earned on average total assets; (3) the rate earned on average common stockholders’ equity; and (4) the availability of earnings to common stockholders. The most widely used profitability measurements are profit margin on sales, return-on-investment ratios, and earnings per share.

Gross Profit on Net Sales

You can use the following ratio to determine the percentage of gross profit on net sales: