Top 4 Financial Ratios to Determine if a Business is Profitable or Not

Determining if a business is profitable is important for new and existing businesses. For startups, you desire to know whether it is a worthwhile venture, while for that old business you wish to verify if the reason for doing it still stands.

This write-up will examine how to determine if a business is profitable using expenses, working capital, and financial statement as measuring tools.

From a nonprofessional’s point of view, you can determine if a business is profitable from the amount invested as startup capital, total operation cost for running the business and total sales for each month to arrive at a profit or loss figure.

If you analyze data of costs less sales revenue, you will know whether the business is profitable or not.

For more explanations on this opinion, read on.

Managing Expenses for Running a Business

To be in business, you have to invest money in different aspects of the business daily, monthly, or yearly. For example, you have to buy raw materials for production, pay rent and salaries, spend money on marketing, advertise goods or services, buy motor vehicles and equipment, and maintain them etc.

Investments and expenditures by their composition, shows that managing costs and increasing sales either leads to a positive or negative outcome, which determines if a business is profitable or not.

Secondly, managing working capital efficiently will minimize wastes, improve profit, and keep business lean and profitable.

Source of Working Capital

Any business venture operating wholly on borrowed funds would struggle to make and retain profit in the business. The first rule to determine if a business is profitable is by finding out the source of its working capital.

In the business world, cash is king and without cash, a business cannot operate. Therefore, you must obtain your working capital in the right way if you do not want your business to fail too soon from heavy debt burden.

Take my advice, owner’s equity should be more than funds from outsiders, to give you the freedom to work for repayment of borrowed money, and not stifle the growth of the business.

If a start-up business has more debt than equity, repayment of principal and interest for loan could make the business unprofitable. To have a profitable business, from the onset, minimize reliance on debt financing.

Read: 10 Sources of Capital and Funds for your Business in Nigeria

Profit and Loss Statement Analysis

A company’s financial statement shows its business activities and profitability for the reporting year and prior year. You can get these reports from investor relations page of publicly quoted companies’ websites, or from corporate disclosures of financial reports page, in Nigerian Stock Exchange website.

For example, if you are analyzing a publicly quoted company, select the company’s annual report and go to the profit and loss statement for any year you wish to examine, and then use financial ratios to analyze the reports.

Let us study some financial ratios to determine if a business is profitable or not.

Top 4 Financial Ratios to Determine if a Business is Profitable

1) Pre Tax Profit Margin Percentage

Pre Tax Profit Margin percentage shows you the volume of profit made per naira sales of a company’s product or service. This figure helps you to discover how much you make from sales per naira.

This ratio calculates the total profit a company makes from sales when you subtract all operations, production, interest and dividends cost, without deducting taxes. Let us assume you got 20% after the calculations, it means that for each N100 sales of goods or services, the company made a profit of N20.

For ratios to make any meaning you must compare present ratios with previous year’s ratios. Also, to get the true profitability of a company you are studying, compare results with its peers in the same industry.

The formula is Profit before Taxation X100 / Sales = Pre Tax Profit Margin Percentage

2) Return on Equity

Return on equity reveals profit earned for every naira of shareholders funds invested in the business after subtracting what you owe (i.e. liabilities). This ratio evaluates the returns a company gets on its shareholders capital, if you consider other investments it could have used the same funds to carry out.

Compare results you get with industry standard to reach a decision on what a good return on equity is. Return on Equity ratio is a crucial ratio because it shows whether a company is profitable or not for investment purposes.

The formula is Net Income / Average Shareholder’s Equity = Return on Equity

3) Net Operating Margin Percentage

Net Operating Margin Percentage calculates the net profitability of a company before removing interest and taxes from it. You get Net Operating Margin Percentage from the ratio of Earnings before Interest and Taxes (EBIT) to Sales.

This ratio means Sales minus all operations costs for running the business without deducting interest owed for debt financing, taxes due to the government and unpaid dividends to shareholders.

This ratio shows you the status of the company without removing amounts allocated for repayment of principal and interest on debt financing. Secondly, it reveals that companies with high Net Operating Margin Percentage are stronger than those without.

To determine whether a business is profitable, first examine the earnings without deducting money set aside for repaying debt, and then compute deducting repayment of borrowed funds with interests to see if it is still profitable.

This ratio will help you decide how much debt is good for a business.

The formula is EBIT / Sales = Net Operating Margin Percentage

4) Gross Margin Percentage

Computing this amount will show the percentage of sales left after subtracting cost of goods, services, or things the company sold to earn gross margin or gross profit.

If the gross profit is high, the net profit too will be high as long as there are no additional costs and expenses that will consume the profit.

To determine if a business is profitable check whether it has high gross margin percentage consistently. If it does, this may imply that it could continue to turn in good results in future.

The formula is Sales – Cost of Goods Sold / Sales = Gross Margin Percentage

Conclusion

Finally, how to determine if a business is profitable rests on the management of human and material resources, working capital structure, cost of running the business, and the amount the company is able to extract from sales per naira from its ordinary business.

If the sales are more than the cost of sales and other expenses and tax put together, the business will make a profit after tax.

Since you are not in business to incur loss, making sure your business is profitable is your full time responsibility.

Keep that in mind.

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