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How to analyse the profitability of your business

by , 29 January 2014
It goes without saying that running a profitable business is your main concern if you own a business. So how do you determine whether or not your enterprise is profitable? Read on to find out how to analyse the profitability of your business.

There are three financial analysis tools you can use to analyse your financial statements, to identity successes or failures before it's too late. These are:

  1. Profitability analysis;
  2. Return on investment analysis; and
  3. Risk analysis.

Note: There are many other categories of tools to analyse your financial information, but these are the essential ones required to evaluate your business.

For the purposes of this article we'll focus on the profitability analysis.

You'll analyse the profitability of your business as follows:

The Practical Accountancy Loose Leaf explains that the profitability of a business is its ability to earn income and sustain growth in both the short and long run (i.e. the sales of the business minus the expenses of the business) and is critical because you want a return on the capital you've invested to set up and run the business.

Why do you need to know this?

A good understanding of the profitability of your business will allow you to invest resources into divisions and products that are the most profitable.

So how do you measure profitability?

There are three ways to measure profitability:

#1: Gross profit %. The gross profit percentage is the profitability of your business before taking into account any fixed costs that aren't directly related to producing the goods or services that are sold and any interest on loans and taxes paid.

Every rand of sales multiplied by your gross profit percentage will give you your gross profit per rand of sale.

#2: Operating profit %. Much like the gross profit percentage, the operating margin percent is the profitability of your business before taking into account any interest on loans and taxes paid.

According to the Loose Leaf , a good operating profit percentage depends on the industry in which you operate. If your gross profit is high, but your operating profit or margin is low compared to the average in the industry – your normal operating expenses are too high.

#3: Net profit %. This measure demonstrates how much overall profit (after deducting all expenses) is made for every rand of sales made.

Businesses with a high net profit percentage are efficient businesses, because they don't incur large costs relative to their revenue.

But, a company with a high net profit margin doesn't necessarily make a large net profit because it may have small sales.

It's important to understand how much you will increase your net profit, or bottom line, if you increase your sales.

Knowing how to analyse the profitability of your business will help ensure you identity successes or failures before it's too late. If you want more information on this, read this article.

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