What Are the Different Ways to Measure Profitability?
Profitability is a key metric in business as companies need to know how much they make from their activities. A few different measures used by businesses include the income statement, gross margin ratio, and return on investment analysis. Each method is proper for measuring financial returns, although a company can only use one if it desires. Profitability is both an internal metric and a benchmark. High profits often indicate a strong ability to reinvest earnings and compete heavily for market share in the business environment.
The income statement represents all sales revenues, cost of goods sold, and expenses for a stated time period. The statement is part of standard accounting procedures and is usually a monthly report. There are two measures of profitability there, with both being important. The first is gross profit, which is sales revenue less cost of goods sold, and represents the amount of money left after paying for the costs related to inventory sold. Gross profit less expenses results in net income, which is the money left for reinvesting into the business.
Gross profit ratios are a similar profitability measure in comparison to the first metric from the income statement. The formula is slightly different here: sales revenue less cost of goods sold divided by sales revenue. This metric works best for determining the profitability on individual products or product lines as well as the overall gross profit ratio. It indicates what percent of every dollar goes to pay for inventory costs. Companies can use this measure to compare itself against other businesses in the industry.
Return on investment is a measurement that reviews the profitability for various projects in which a company engages. The classic formula here is investment gain less investment cost divided by investment cost. Companies can typically use this as a preproject profitability measurement as they look to find the most profitable projects among several options. In most cases, companies desire selection of the most profitable projects as these will add to the bottom line and not create a drag on company resources. Other profit measures are necessary to compare profits after the project is up and running.
Hybrid profit metrics or other profit measures may be more appropriate for a company. These may include time value of money measurements, the statement of cash flows, or return on equity ratios. In short, there is really no end to the methods available when measuring profit. The company must simply assess the formula against the need and select the appropriate profitability measure.
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