7 Profitability Ratios and KPIs you need to know

7 Profitability Ratios and KPIs you need to know

This week we’re looking at key performance indicators (KPIs) and financial ratios! Sounds hard? I’ll be explaining them, step-by-step in this guide.  

As someone without a financial background, ratios and KPIs made absolutely no sense to me at first. I didn’t understand what they were calculating, or what they were supposed to be used for.

While many of these are obvious to financial professionals, few can be guessed at from their name (EBITDA, anyone?). Their usage isn’t always clear either. So what if your operating profit margin is 40%  – is this ‘good’? I remember when I started in financial software I struggled to identify what these metrics actually mean in a business sense, and what I should do with the information they provide.

For many small businesses, ratios, KPIs and financial metrics are part of the alien language of big-business financial analysts and consultants. But some of these calculations are actually quite simple – are just as effective at giving small businesses meaningful, useful information as they are for large corporates.

In this article I’ll describe 7 of the most popular profitability ratios, explaining in layman’s terms how each one is calculated.

For each one, I’ll also show in practical terms how these metrics can be used to learn more about your business.

Profitability Ratios

Profitability ratios show how well the business generates profit. 

These ratios measure different definitions of profit against other elements of the business, such as the revenue it receives. 

Before I go further, let’s look at these different definitions of profit. Each of these is a KPI in its own right, a means of measuring the business’ performance.

Here’s an example: My grocery stall company brings in £5,000 Revenue a month. 

After I incur the expenses of running the stall (site permit, insurance, cost of buying the produce I am selling, my salary, taxes) the grocery business only has £1,000 left. 

But it is only Net Profit which includes all of these expenses in its calculation – Gross Profit and Operating Profit include fewer expenses and tell us different things about the business as a result.

Gross Profit

Gross Profit is the money the business makes after deducting the expenditure directly related to the business’ sales activities.

Here’s an example using my grocery stall business. My revenue is £5,000, and the directly related costs of supplying and packaging the produce I sell is £1,300. 

Revenue:                                      £5,000
Expense – cost of produce    £1,300
Gross Profit:                                £1,000

What does ‘directly related’ mean? Think about it like this – what costs would increase if you sold two of something instead of one?  Another way of referring to these costs is ‘variable costs’. If more items are sold, these costs increase in line with the increase in sales.

In product-based businesses, these can be easy to identify – for example, the raw materials used to make a product, or the cost of packaging that the product is sold in. 

These variable costs are sometimes referred to as the ‘material cost’, ‘direct cost’,’ ‘cost of goods sold’ (COGS), or more generically, ‘cost of sales’.

The cost of sales can be harder to identify in a service-based business. 

For example, if you run a consulting firm and sell consulting days, the cost to the business of running a consulting day is the consultant’s time (which you might account for as a direct cost, or a staff cost), as well as any travel or technology costs that are required for the consultation to go ahead.

Gross Profit Business Use 

Gross profit shows how effective the business is at producing income from the costs of producing the products or services that generate this income.

On its own, gross profit shows the earning potential of the business. It answers the question ‘How much can the business make from its selling operations if all other costs are excluded?’ 

Breaking this down further, by department or product/service type can be a great way to see how profitable different parts of the business are. Poorly performing parts of the business could be identified and improved, while particularly profitable elements could be given more focus. 

These two methods make gross profit both a great, quick metric for understanding a business’ ability to generate profit, and also a useful tool to investigate where the business’ profitability comes from.

Operating Profit

Next up is Operating Profit. Sometimes referred to as EBIT (Earnings Before Interest & Tax), the profitability metric is similar to gross profit. Where gross profit includes just variable costs, operating profit also includes the ‘fixed costs’ of the business. 

Fixed costs are expenses that do not fluctuate as sales increase or decrease. Utility bills like heating and electricity, staff salaries, insurance payments and all of the conventional costs of ‘being a business’ are fixed costs.

Operating profit also includes depreciation/amortisation – expenses that record the loss in value of things over time. For example, if I buy a computer for the business, a year later that computer will be worth less than when I first bought it – which could be relevant if the business ever needs to sell any of its assets to raise funding. 

While depreciation isn’t a ‘cost’ that the business has to pay – it is considered an expense on the profit and loss statement – as the business is losing something of value (this is one of the reasons why profit and loss statements and forecasts can be confusing…). Businesses which own a large number of assets often have high depreciation losses, which impacts their operating profit severely.

Amortisation (or amortization if you prefer…) refers to the accounting practice of spreading an intangible asset’s cost over its lifetime. Unlike fixed assets like chairs and computers, intangible assets are things the business owns that have value but are not actually physical objects. Patents, brands and intellectual property are intangible assets. 

What isn’t included in the operating profit calculation are interest expenses and income associated, income or expenditure from the business’ investments or any tax expenses. Think of operating profit as being a measure of the business’ everyday activities – and how these contribute to the profitability of the business as a whole.

To continue our grocery stall example, our operating profit looks like this:

Revenue:                                      £5,000
Expense – cost of produce    £1,300
Expense – site permit              £100
Expense – insurance                £90
Expense – depreciation          £10
Expense – salary                        £1,500
Operating Profit:                        £1,000

As you can see, this figure is dramatically different from the same business’ gross profit! It also tells us different things about the business.

Operating Profit Business Use 

While the grocery stall makes quite a lot of gross profit, its other business overheads, particularly salaries, reduce its operating profit significantly.

Operating profit is useful for measuring a business against others of a similar size, or in a similar sector. Unlike gross profit, operating profit shows how well the business utilises its resources outside of its main selling operations. Does the business run a ‘tight ship’ or is there overspending in certain areas that do not materially affect the business’ profits? It may be that this spending is an important part of the business – culturally or in terms of brand awareness, but comparing operating profit across similar businesses will highlight this.

Operating profit isn’t a full view of the business’ financial position however – and business with a healthy operating profit can still be heavily in debt. Debt expenses and taxes are included in the final type of profit…

Net Profit / Profit

When people talk about ‘profit’ they usually mean ‘Net Profit’ – what the business is left with after all of its variable costs, fixed costs and interest, investment and tax expenses have been paid.

Here’s our grocery stall’s final profit calculation:

Revenue:                                      £5,000
Expense – cost of produce    £1,300
Expense – site permit              £100
Expense – insurance                £90
Expense – depreciation          £10
Expense – salary                        £1,500
Expense – tax                              £1,000
Net Profit:                                     £1,000

Net Profit Business Use

Net profit is an incredibly important metric for measuring businesses. It is, in some senses, the ‘bottom line’ when it comes to tracking business performance. 

As with any single metric, what net profit doesn’t show though is the direct cause of a profit or loss in a given period. As it includes all of the business’ activities as part of its calculation there are many factors which could result in a good or bad net profit month-to-month. 

Looked at together, these profit definitions form the basis of a Profit & Loss Statement, one of the ‘Big three’ financial reports.

Revenue:                                      £5,000
Expense – cost of produce    £1,300
Gross Profit:                                 £3,700
Expense – site permit              £100
Expense – insurance                £90
Expense – depreciation          £10
Expense – salary                        £1,500
Operating Profit:                       £2,000
Expense – tax                              £1,000
Net Profit:                                     £1,000

If you want to learn more about how these types of profit sit in a full version of the profit and loss statement, check out the Beginner’s Guide to Profit and Loss.

 

Understanding Profit Margins

In addition to expressing profit as a figure, each of the types of profit described above can be expressed as a percentage. These are called profit margins. 

Gross Profit Margin

Gross Profit Margin Calculation:

Gross Profit Margin = Gross Profit / Revenue
Grocery Stall Gross Profit Margin = (3700 / 5000) x 100
Grocery Stall Gross Profit Margin = 74%

£3700 divided by £5000 equals 0.74. This means that for ever pound the business spends it makes £0.74 in gross profit. To express this as a percentage, we multiply the result by 100 to reach a gross profit margin of 74%.

You can use the same method for the other 2 profit margins:

Operating Profit Margin Calculation:

Operating Profit Margin = Operating Profit / Revenue
Grocery Stall Operating Profit Margin = (2000 / 5000) x 100
Grocery Stall Operating Profit Margin = 40%

Net Profit Margin Calculation:

Net Profit Margin = Net Profit / Revenue
Grocery Stall Net Profit Margin = (1000 / 5000) x 100
Grocery Stall Net Profit Margin = 20%

Profit Margin Business Use 

Using a percentage margin rather than actual profit amount makes it easier to compare a business to others – as while the figures involved may be very different the % margins always tell the same story. This makes margins a particularly good way to compare a business’ performance against other businesses in the same sector.

In addition, by tracking changes in profit margin over time (say, 12 months) it is easier to see trends emerge than when just looking at figures.

EBITDA

To finish off we have one of the most opaque acronyms I’ve come across in financial planning. EBITDA. Even when you know what EBITDA stands for, it takes a degree of accounting knowledge to understand what it describes. So, what is it, and is it worth the effort?

EBITDA stands for:

Earnings Before Interest, Tax, Depreciation and Amortisation.

It is, simply, another way to slice the profit pie that we’ve been looking at through this article.

So, what does this mean in the terms we’ve been using?

Earnings is revenue.

Interest is interest paid on borrowing in the plan.

Taxation is tax the business pays based on its profits.

Depreciation and Amortisation are losses in value of assets.

How would we calculate this? A simple way it to take Operating Profit (remember another name for this was EBIT – Earnings Before Interest and Tax) and add back in depreciation and amortisation. These are already included in Operating Profit, and so EBITDA will be a higher figure than Operating Profit.

Grocery stall EBITDA:

Revenue:                                      £5,000
Expense – cost of produce    £1,300
Expense – site permit              £100
Expense – insurance                £90
Expense – salary                        £1,500
EBITDA                                           £2,010

EBITDA Business Use 

Businesses with a large number of depreciating assets, or highly valued intangible assets can get the most out of using EBITDA as a measure of their businesses. 

It provides a means of stripping away these elements from Operating Profit, and thus show a truer picture of the businesses’ day to day operating profitability, without including massive deductions from depreciation and amortisation.

This is particularly useful in sectors such as housing management, where depreciation is often a major expense.

 

More ratios and financial metrics coming soon!

We’ll be back later this summer with guides to more key performance indicators, as well as a new Brixx report to showcase these metrics in your Brixx financial forecasts. Stay tuned 🙂

 

Robin Booth 30th July 2019 By
 

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