How To Determine The Profitability Of A Company

One of the most important things you need to know about a company is if it is making profits or not. These tools will help you determine that

One of the biggest mistakes a lot of people make in relationships is not knowing exactly what they want from relationships from the onset. As such, halfway into it, they start to want more or regret why they started in the first place.

In an earlier article, we established the need to use proper metrics to correctly evaluate the value proposition.

In cases where money is the value requirement, there is also a need to properly evaluate the degree of it. While you can determine the size of your partner’s pocket based on the the kind of car driven or the size of the house they live in, in business your eyes need to be fixed on profitability.

There are different metrics used to determine the profitability of a company and its ability to remain profitable. One of such methods is through the computation of ratios. Here are some of the popular ratios used.

Gross Profit Margin

The Gross Profit margin is simply the percentage derived by dividing a company’s gross profit by its revenue. The Gross profit is determined by subtracting all costs that are directly related to the derivation of the revenue in the first place.

For example, if you are in the business of making shoes, the raw materials used to make the shoes would be deducted as direct expenses. This is the amount that needed to make the revenue in the first place. The Gross profit value is then divided by the total sales made to determine the profit percentage.

EBIT or EBITDA Margin

Depending on what you want to test for, you can either use the EBIT Margin or the EBITDA Margin to determine profitability. While EBIT stands for “Earnings Before Interest and Tax”, EBITDA stands for “Earnings Before Interest Tax, Depreciation, and Amortization.”

EBIT shows exactly how much profit has been made before non-operating items like interest repayment and tax deductions are made. The EBITDA Margin shows the same thing while also showing the exact cash position without non-cash items being considered. The resulting figure is divided by revenue to determine the ratio.

Net Profit Margin

Following closely from gross profit margin, net profit margin involves determining the gross profit of the business and further subtracting other expenses. The resulting figure is divided by sales to determine the net profit margin.

The net profit margin is used to determine the net amount of earnings generated in a reporting period. It is also important to note that If the accrual basis of accounting is used, the resulting figure might be different from what cash flows would indicate, due to the accrual of expenses that have not yet occurred. The margin gives you a full view of the profitability of the company.

For stock market investors, profitability can be measured in terms of returns. The best ratios used to determine return rates are:

Return On Assets (ROA)

This is to show how much return was generated based on the assets used to run the business. To calculate this, simply divide the net profits by the total amount of assets in the balance sheet.

Return On Equity (ROE)

To compute the return on equity, simply divide net profits by the total amount of equity that is stated on the balance sheet.

Upon computation, you can compare against industry standards and trends to correctly evaluate performance. The Yochaa App also shows other performance indicators like dividend yield and all of these metrics will show you exactly how a business is faring and provide you with the tools to make informed decisions.

Written by Lawretta Egba