Do You Know How To Measure Your Profits?

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Are you an entrepreneur looking for investors? then one of the best ways to convince potential business partners is by understanding your company’s financial statements. Are you an investor looking for shares to buy? Are you wondering if you will make a profitable investment? then the first thing you should pay attention to are financial ratios of the company you want to invest in. In this article, guest writer Albena Neyra explains how financial ratios can help you analyse the financial strength of a firm, by introducing four profitability ratios you should master.

1.The Gross Margin Ratio tells you what percentage of sales can be used for expenses and profit.  It is calculated after the Cost of Goods, the direct cost of purchasing items for resale or the inputs for production or construction (such as raw materials, manpower, tools, packaging, etc) have been deducted from sales. So Revenues minus Cost of Goods equal Gross Profit. Gross margin varies between industries and often varies between companies within the same industry. For example, a Gross Margin ratio of 41% indicates that 59% on the value of revenue is available to cover running expenses, financial costs and profit.

Ratio Calculation Example
Gross Margin = (Gross Margin) / (Revenue) x 100% Revenue  = 4,130,000   Cost of Goods  Sold = 2,436,000  Gross Margin =  4,130,000 – 2,436,000 =  1,694,500            Gross Margin as % of Revenue   =  (1,694,500 / 4,130,000)=                  41%

2.The Profit Margin indicates how much profit a company makes out of every sale (revenues) and after all expenses is deducted from gross margin. So, net income equals revenue minus expenses. Net income will vary between industries as well as between companies in the same industry. A profit margin of 9% over sales is considered satisfactory and means that for every pound of sales the company makes 9% profit.

Ratio Calculation Example
Profit Margin = (Net Income) / (Revenue) Net Income     =  354,640                    Revenue          =  4,130,000              Profit Margin  = 354,640 / 4,130,000=                9%

3.Return on Equity Ratio (ROE) indicates how much shareholders gained from investing in a company. It is the percentage of profit after interest and income taxes over equity during the year. If a corporation has preferred shares, the preferred dividends must be deducted from the net income. Investing in a high ROE firm is considered a profitable investment for shareholders. The ROE compares with the return from other investments available to shareholders, as is the case with shares in the stock exchange, government bonds, currency trading, and real estate.

Ratio Calculation Example
Return on Equity = (Profit or Loss) / (Equity) Net Income   = 354,640                        Equity = 1,115,023                                  ROE = 354,640 / 1,115,023 = 32%

What is a good return on equity? Below are shown different levels of ROE indicating the quality of return for the investors in a firm.

Return on Equity

Satisfactory Good Very Good Excellent

< 10%

10% – 15%

15% – 20%

>20%

4.The Return on Initial Investment (ROI) shows the percentage of profit after interest and income taxes over the initial invested capital by owners at the start of operations of the firm. It is a useful ratio when analysing the worthiness of an investment in a start-up firm. When compared with the rate of interest on savings if investor’s funds are kept, say, in a bank, a 44% ROI is well above the bank savings rate, which typically varies from 2 to 5% depending on the country and the term of savings. The ROI compares with the return from other investments available to shareholders, as is the case with shares in the stock exchange, government bonds, currency trading, and real estate.

Ratio Calculation Example
Return on Initial investment (ROI) = (Profit or Loss) / (Initial investment) Net Income  = 54,640              Initial Investment  =  800,000   ROI = 44%

This article was written with Albena Neyra, co-Founder of entreprenable.com, an online platform that provides quality business education available to all, which uses an innovative teaching methodology that demystifies accounting and financial management. It is a web business education of MBA quality, learnt in a short time, at an affordable cost and accessible to entrepreneurs, investors and managers, without barriers of entry. The information in this article was taken from the Business Finance course.

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