In strategic planning, profitability ratios tell you how well you create financial value for your company. Although net profit is your bottom line, profitability is what you’re aiming for year after year. This activity looks at the profitability of your company as a whole, which includes net profit margin and return on equity (ROE):
Net profit margin: Net profit margin is calculated by dividing gross sales into net profit. If your net profit margin is low compared to your industry, that means your prices are lower and your costs are too high. You aren’t efficient. Lower margins are acceptable if they lead to greater sales, more market share, or future investments, but make sure that they don’t go too low. High margins are typically never a bad thing. Watch this ratio each year and use your industry average as a gauge to monitor your performance.
Return on equity (ROE): ROE measures how much profit comes back to the owners for their investment. This ratio is calculated by dividing net profit by the owner’s equity investment.
The fictional Konas Corp. has a net profit of $65,000 and gross sales of $778,000 for a pre-tax profit margin of 8.3 percent. In other words, the company is making 8.3 cents on every dollar. The owners of Konas have an equity investment of $294,000 in the company, so with a net profit of $65,000, their ROE is 22 percent. This percentage means that the owners make almost 22 cents on every dollar invested in the company as equity. A 20 percent ROE is a reasonable return for risking $294,000.