Finance for Non-financial Managers

4. Measuring Profitability

4.1 Your profit margins can be calculated from the profit and loss statement (see 1.2).

• The gross profit margin is gross profit as a percentage of turnover.For example, if your turnover is £200,000 with a cost of sales of £60,000, you have a gross profit of £140,000 and a gross profit margin of 70 per cent.
• The operating (or net) profit margin compares operating profit (ie after taking account of indirect cost) to turnover.For example, turnover of £200,000 and operating profit of £30,000, the operating profit margin would be 15 per cent.

4.2 You can compare profit margins to get a clearer picture of your performance.

• Compare profit margins to other companies to highlight where you are doing well and where you should improve.
• Compare profit margins to previous periods to see where your selling prices are coming under pressure or costs are increasing.
• Compare profit margins on individual product lines to see which products are the most profitable.Although the formal profit and loss statement will not give this level of detail, your internal management accounts should.

4.3 Profit margins tell you how much room for manoeuvre you have on pricing and what sales you need to break even.

• As long as you have a positive gross margin, each sale will make some contribution to covering your overheads.
• Dividing your total overheads by your gross margin tells you what sales you need in order to break even.For example, with overheads of £50,000 and a gross margin of 25 per cent, you will reach break even with turnover of £200,000 (ie £50,000 ÷ 25 x 100).
• If you decrease your margins (eg by reducing prices), you will need to increase sales to maintain the same profits.

4.4 Comparing profits to assets also provides a measure of profitability.

• Return on capital employed is PBIT as a percentage of capital employed.This shows what return you are making on the money financing the business (both as loans and shares).
• Return on equity is profit before tax (but after interest has been deducted) as a percentage of shareholders funds.

4.5 Some businesses will find other measures of profitability more appropriate.

For example:

• A retail business might focus on profits per square foot of shop space.

4.6 You (or your accountant) can also use your accounts to get further information on your financial position.

Areas which businesses focus on include:

• Growth.For example, comparing sales from one period to the next.
• Financial strength.For example, looking at how large a proportion of your financing is borrowed, and how well you could cope if business conditions became difficult.
• Control of working capital (ie current assets less current liabilities). For example, how much money you have tied up as stock, how efficient you are at collecting debts, and how quickly you pay suppliers.