What Is Profitability? - Definition & Analysis

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  • 0:41 Net Profit Margin
  • 1:42 Gross Profit Margin
  • 2:39 Operating Margin
  • 3:51 Return on Assets
  • 5:01 Return on Equity
  • 5:58 Lesson Summary
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Lesson Transcript
Instructor: Shawn Grimsley
Profitability determines whether a business stays in business. In this lesson, you'll learn about profitability and different ways to analyze it. A short quiz follows the lesson.

Definition of Profitability

Profitability is the ability of a business to earn a profit. A profit is what is left of the revenue a business generates after it pays all expenses directly related to the generation of the revenue, such as producing a product, and other expenses related to the conduct of the business activities.

There are many different ways for you to analyze profitability. This lesson will focus on profitability ratios, which are a measure of the business's ability to generate revenue compared to the amount of expenses it incurs. Let's look at a few of the primary analytical approaches.

Net Profit Margin

Net profit margin measures the profitability of your business. The formula is:

Net profit margin = (net income / net sales) * 100 (We multiply by 100 to make the result a percentage)

Let's say you have net income of $100,000 and net sales of $1,000,000. What is your net profit margin?

Well, we know net profit margin = (net income / net sales) * 100, so net profit margin must equal $100,000 divided by $1,000,000 times 100.

  • (100,000 / 1,000,000) * 100
  • 100,000 / 1,000,000 = 0.1.
  • The net profit margin equals 0.1 times 100.
    • 0.1 * 100
  • So the net profit margin in this example is equal to 10%.

This means that for every dollar you make in sales, you earn a dime in net income.

Gross Profit Margin

Gross profit margin measures the cost of production. The formula is:

Gross profit margin = (gross profit / net sales) * 100.

Let's say you have a gross profit of $125,000 and a net sales of $3,750,000. What is your gross margin? Gross profit margin = (gross profit / net sales) * 100, so in this example:

  • Gross profit margin = ($125,000 / $3,750,000) * 100
  • Therefore, the gross profit margin equals 0.03 times 100.
    • 0.03 * 100
  • Gross profit margin = 3%

A gross margin of 3% means that out of each dollar you make in sales; you spend a little over 97 cents to produce the product.

Operating Margin

Operating margin tells you how much costs unrelated to producing the product for sale are cutting into your profits. Costs unrelated to production can include such things as general business, staff and administrative expenses of the business. Net operating margin is often referred to as your earnings before interest and taxes or EBIT. The formula for this is:

Operating margin = (operating profit / net sales) * 100

Let's take a look at an example.

You have an operating profit of $90,000 and net sales of $1,000,000. What is your operating margin? Well, we know that operating margin = (operating profit / net sales) * 100, so:

  • Operating margin = ($90,000 / $1,000,000) * 100
  • Operating margin equals 0.09 times 100
    • 0.09 * 100
  • The operating margin equals 9%.

This tells you that you spend nine cents out of every dollar you make in sales for business expenses not related to production.

Return on Assets

A return on assets, or ROA, measures how effectively and efficiently you are using your business assets to generate profit. The formula for ROA is:

Return on assets = (net income / total assets) * 100

Let's say your business has assets of $5,000,000 and generates a net profit of $750,000. What is your return on assets? Since return on assets = (net income / total assets) * 100, use this ratio with the given numbers.

  • Return on assets = ($750,000 / $5,000,000) * 100
  • $750,000 / $5,000,000
  • Therefore, return on assets equals 0.15 times 100
  • Your return on assets would equal 15%.

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