Measure and Grow Profitability With These 3 Business Measures of Performance
If someone stopped you on the street tomorrow and asked how profitable your business is, would you be able to answer without hesitation?
And when it comes time to file your business taxes every year, do you ever find that either:
1)Your business was not as profitable as you thought OR
2) You earned more than you thought but didn’t leverage your profits to invest in growing your business?
If any of these sound like you, you’re not alone.
Many of the small business owners I’ve worked with over the years know that they should be tracking their profitability but often have no idea where to start. They simply pay themselves a distribution when they need money for their personal account. I used to do this in the early stages of my business too until I saw how this approach hurt my family’s financial position.
So to prevent you from making the same mistakes I did in my business, I’m going to share 3 simple ways to measure profitability so you can grow your business with confidence.
The Importance of Knowing How to Measure Profitability
If you want a business that gives you the freedom to pay yourself, save for retirement, or grow your impact, you have to be able to pinpoint what drives profits in your business so you can intentionally create more of them (without burning out).
You’ll often hear me say, “What you own, you can change.”
Knowing how to measure profitability is the first step to truly owning your business. It allows you to choose profit rather than hoping or wishing that it happens by luck.
Measuring the profitability of your business is the first step to growing a sustainable business that allows you to leave a legacy rather than just work paycheck-to-paycheck (or distribution-to-distribution).
Out of all the business measures of performance out there, there are three key ratios that can help you uncover the true profitability of your business. Let’s take a look at how to use them to save time and make proactive changes in your business as needed.
Your Business Profit Margins Simplified
Profit margins are expressed as a percentage (or ratio) to show you the percentage of the money left after expenses have been taken out.
When someone refers to “profit margin,” it can be hard to know which exact profit margin they are referring to because there are several different layers of margins.
What do I mean by layers?
As you might notice in your Profit & Loss statement, your business has several different layers of expenses. Each profit margin ratio is a representation of your profitability after each layer of expenses has been taken out.
So let’s break down the three profit margins that will help you maximize your profits no matter what happens in the economy or the world.
#1) Measure Profitability of Sales With Gross Profit Margin
When you earn revenue by generating sales, the first layer of expenses that comes off the top of your profits is Cost of Goods Sold (abbreviated as COGS). These are expenses that are directly tied to each revenue-generating activity, such as the cost of labor associated with performing a task for a specific project.
When you subtract your COGS from your revenue, you get Gross Profit.
Gross Profit = Revenue - COGS
Your gross profit shows you the amount of money you can use to pay for operating and general business expenses or reinvest into your business.
When you divide gross profit by your revenue, you get the Gross Profit Margin.
Gross Profit Margin = Gross Profit / Revenue
As a measure of profitability, the gross profit margin helps you see how much it’s costing you to generate a certain level of sales.
Increase Profitability By Reducing Your COGS
If your revenues are growing but your gross profit margins are dropping or staying around the same level, you may want to assess the costs related to each revenue-producing activity. Depending on the type of business you’re in, your COGS could go either up or down when you make new sales.
In a service-based business, for example, you may experience upfront costs when you onboard a new customer or client. If you have someone on your team handling paperwork for every new client, you might see your gross profit margin dropping in the months when you onboard more new clients. Yet in the long-run, these clients may then lead to more work without incurring additional costs tied to signing on a new client.
#2) Measure Operating Profitability With Operating Margin
Once you have your gross profit, you can then calculate your operating profit by subtracting your operating expenses from your revenue. Operating expenses are expenses that help you keep the business running regardless of the level of sales you’re generating (like rent, internet and telephone bills, or software subscriptions).
Operating Profit = Gross Profit - Operating Expenses
You can then take the Operating Profit and divide it by Revenue to get your Operating Margin.
Operating Margin = Operating Profit / Revenue
As a measure of profitability, the operating margin helps you see how much it’s costing you to generate revenue and cover your operating business expenses.
Increase Profitability By Reducing Operating Expenses
If your gross profit margins are growing but your operating margins are dropping or staying around the same level, you may want to assess your operating expenses to see where you might eliminate or reduce the ones that aren’t consistently contributing to revenue.
If you have a business budget, this could be the first place to look so you can see if you’re overspending in certain categories. If not, this could be a great reason to invest some time into creating a business budget. (You can learn how to create a business budget in 3 simple steps here.)
#3) Measure Overall Profitability With Net Profit Margin
Once you know your operating profit, you can get an even better reading of your profitability by taking out the cost of taxes or interest on business debt.
Your Net Profit is what’s left after you’ve subtracted your tax and interest costs from your Operating Profit.
Net Profit = Operating Profit - Taxes and Interest on Debt
You can then take the Net Profit and divide it by Revenue to get your Net Profit Margin.
Net Profit Margin = Operating Profit / Revenue
To grow your net profitability, it’s helpful to look for ways you can reduce your COGS, operating expenses, AND your taxes and interest costs without adversely affecting your revenues.
Increase Net Profitability by Reducing Your Tax and Interest Costs
If your operating margins are growing but your net profit margins are dropping or staying around the same level, you may want to review your business taxes and interest costs to increase your overall net profit margin.
If you’ve borrowed any money for your business, one strategy to maximize your profit is to see if it may be possible to refinance your debt to minimize interest cost.
One unavoidable expense that every business will have to pay is taxes. And while this article is beyond the scope of providing tax advice, some things to consider to help you reduce your tax bill as a small business owner include:
Know what type of corporate structure is best suited for your business (LLC, S-Corp, C-Corp, Sole Proprietorship)
Set aside money for retirement in tax-sheltered retirement accounts such as IRAs, SEP IRAs, or Keogh plans
Utilize employee benefits such as health insurance to provide for your employees while increasing your business deductions
It’s best to speak with your CPA or tax advisor about these topics to see if you’re missing any opportunities to lower your taxes as your business or tax laws change.
Give Yourself a Pay Raise or Invest Into Your Business?
Once you know what drives most of your business profit, you’ll be able to make even more exciting decisions. Will you pay yourself more in distributions or invest profits back into your business to keep it growing? That’s ultimately up to you and your goals.
Creating a profitable business means finding ways to maximize your revenues while minimizing your expenses. Understanding these measures of performance in your business is a great step to simplifying your life as a small business owner.
Once again, the three measures of performance to help you measure and grow profitability are:
Gross Profit Margin
Operating Margin
Net Profit Margin
And the best part about using these great profitability measures effectively? You don’t have to reach for your calculator (or phone) to crunch any of the numbers yourself. When you sign up for Metrique, it will calculate your profit margins for you!
Plus, you’ll be able to track and visually see the progress you’re making each month so you can confidently make changes to your business as needed. Watch this quick demo to see how Metrique can help you measure and track profitability in your business.
Here’s to growing your profits while spending more time doing what you love!