When running a small or medium-sized business (SMB), it's important to keep your eye on the bottom line. Profits can be reinvested in your business to help it grow, while losses need to be stopped and reversed to survive.
Profits and losses need to be understood in various ways to reveal different aspects of an SMB's financial performance, whether it is three different calculations for profit margins or a calculation for net income, an accounting equation, a break-even point formula, a calculation for return on investment, and how to arrive at the cost of goods sold (COGS).
What Is a Profit Margin?
In brief, a profit margin or percentage reveals how much profit your small business generates for each dollar of sales. So, a 30% profit margin reveals that you have a net income of 30 cents of profit for every dollar of sales.
The profit margin calculation reveals what percentage of revenue small business owners keep after taking care of outgoing expenses. There are three main ways to determine profit margin: net profit margin, gross profit margin, and operating profit margin.
How to Calculate Profit Margin
By calculating your company's profit margin and profitability ratios, you can better keep track of your SMB's financial health, have a strong basis for making business decisions, and rectify financial problems before they get worse. The ways to use profit margin calculators include:
Net Profit Margin
Net profit margin is the famous bottom line, reflecting the total amount of revenue remaining after total expenses and additional income are calculated. It includes debt payments, taxes, one-time expenses, and investment income.
You can calculate your small business's income with this net profit margin formula:
| Net Profit Margin | ||||
|---|---|---|---|---|
| = |
|
× 100 | ||
If you don't know your net income, you can use this formula:
| Net Profit Margin | ||||
|---|---|---|---|---|
| = |
|
× 100 | ||
| Costs = Cost of Goods Sold + Operating Expenses + Other Expenses + Interest + Taxes | ||||
Gross Profit Margin
The formula for gross profit margin is the simplest of the three, determining profit as all remaining income after taking into account the cost of goods sold. It excludes overhead costs, such as rent and utilities, and expenses for debt, taxes, and one-time expenditures. For the most part, the calculation for the gross profit margin equation is employed to arrive at the profit margin of a single service or product, as opposed to the profit margin for a business as a whole.
The gross profit margin formula is:
| Gross Margin | ||||
|---|---|---|---|---|
| = |
|
× 100 | ||
Operating Profit Margin
This is a more involved calculation, encompassing your overhead, operating, administrative, and total sales expenses used to operate the business daily. It doesn't include non-operational expenses, such as debt and taxes, and other non-operational expenses.
The operating profit margin formula is:
| Operating Profit Margin | ||||
|---|---|---|---|---|
| = |
|
× 100 | ||
Other Important Small Business Calculations
Whether it is understanding where your small business breaks even, how to determine the profitability of an investment, or how your assets stack up to your liabilities, these other small business calculations offer different windows into your financial picture.
Net Income Calculation
Also known as net earnings, net income is calculated by subtracting expenses, interest, and taxes from revenues. The number appears on your income statement and is an important indication of your profitability and financial health. Potential lenders and investors will look at this number closely since it shows by how much your revenues exceed your expenses.
While net income can apply to a single person's income after taking account of taxes and deductions, a business would start with its total revenue and subtract expenses and operating costs to find its earnings before tax. Then, subtract tax from this figure to determine the net income.
Put simply, the formula is:
| Total Revenues |
| − Total Expenses |
| = Net Income |
The Accounting Equation
The basic accounting equation continues to act as the basis of double-entry accounting - ensuring that every transaction recorded on the debit side has a corresponding entry on the credit side. Also known as the balance sheet equation, the accounting equation works on the basis that every business asset has a claim against it in the form of a liability or owner's equity.
Equity can be the owner's equity, shareholder's equity, or stockholder's equity, representing the funds available to them. The accounting equation determines how the balance sheet's three important categories are related to one another: assets, liabilities, and equity.
The accounting equation is simple, not taking into account the types of assets and liabilities on the balance sheet:
| Liabilities |
| + Owners' Equity |
| = Assets |
Break-Even Point Formula
Your company's break-even point is when revenues equal expenses. Knowing this point is important because it lets you know how much more money you need to make before you can turn a profit.
To determine your break-even point, you must first calculate your contribution margin (i.e., your business's revenue minus its variable costs). Your contribution margin percentage is found by dividing your contribution margin by your total revenue.
To determine how many units you need to sell before breaking even and then turning a profit, you need to take into account factors like:
- Fixed costs
- Variable costs
- The selling price of the product
The formula to determine your break-even point is:
| Break-Even Point in Units | |||
|---|---|---|---|
| = |
|
||
Or:
| Break-Even Point in Units | |||
|---|---|---|---|
| = |
|
||
Return on Investment Calculation
One of the most common ways to determine return on investment (ROI), or the profitability of an investment, is by dividing net profit by total assets:
| ROI | |||
|---|---|---|---|
| = |
|
||
Using this formula, if your net profit is $40,000 and your total assets are $160,000, your ROI would be 25%. Small businesses might use the calculation to measure how well their pricing strategy does or how well their investments in inventory or equipment perform. By knowing the ROI, or profit margin percentage, you can determine if an investment is worth the price or whether you should be looking for a better alternative.
Cost of Goods Sold (COGS) Calculation
SMBs have to keep track of the direct costs and indirect costs involved in producing and distributing their products for sale. The COGS calculation serves as the basis of profit and loss (P&L) statements and must be part of the information you report at tax time.
COGS is subtracted from your gross receipts (the amount you generated from sales revenue) to determine the gross profit for your business annually. The COGS formula tracks changes to inventory, starting with the inventory for sale at the beginning of the year (or the raw materials needed to make products).
As new products are added or produced throughout the year, they are also added to the calculation. The end-of-year inventory is then subtracted, showing the cost of inventory produced and sold by the business.
So, the COGS formula is:
| Beginning Inventory |
| + Purchases and Other Costs |
| − Ending Inventory |
| = Cost of Goods Sold for the Year |
Keep Better Control of Your Finances With Skynova
When you launch a small business, it is essential that you keep track of your finances (including the company's profitability) so you can grow confidently and avoid pitfalls. Left unchecked, losses and liabilities can destroy your venture.
Skynova's accounting platform can play a pivotal role in how you do your bookkeeping. It is simple to use (no professional accounting experience required), easy on the pocketbook, and has all the accounting features you need to record an accurate financial picture, keep track of your income and expenses, monitor your tax situation, automatically record transactions, produce revealing financial statements, and much more.
With Skynova, you can easily calculate your profit margins and watch while you increase profits and cash flow.
Notice to the Reader
The content within this article is meant to be used as a general guideline and may not apply to your specific situation. Always consult with a professional accountant to ensure you're meeting accounting standards.