Using an Income Statement to Test a Business’s Profitability
With an income statement, you can do a number of quick ratio tests of your business’s profitability. You want to know how well your business did compared to other similar businesses. You also want to be able to gauge your return (which means what percentage you made) on your business.
Three common tests are Return on Sales, Return on Assets, and Return on Equity. These ratios have much more meaning if you can find industry averages for your particular type of business, so you can compare your results. Check with your local Chamber of Commerce to see whether it has figures for local businesses.
Return on Sales
The Return on Sales (ROS) ratio tells you how efficiently your company runs its operations. Using the information on your income statement, you can measure how much profit your company produced per dollar of sales and how much extra cash you brought in per sale.
You calculate ROS by dividing net income before taxes by sales. For example, suppose your company had a net income of $4,500 and sales of $18,875. (If your business isn’t a corporation but rather is run by a sole proprietor, you don’t have to factor in any business taxes because only corporations pay income taxes.)
The following shows your calculation of ROS:
Net income before taxes ÷ Sales = Return on Sales
$4,500 ÷ $18,875 = 23.8%
As you can see, your company made 23.8 percent on each dollar of sales. To determine whether that amount calls for celebration, you need to find the ROS ratios for similar businesses. Again, check with your local Chamber of Commerce, or order an industry report online from BizMiner.
Return on Assets
The Return on Assets (ROA) ratio tests how well you’re using your company’s assets to generate profits. If your company’s ROA is the same or higher than other similar companies, you’re doing a good job of managing your assets.
To calculate ROA, you divide net income by total assets. You find total assets on your balance sheet. Suppose that your company’s net income was $4,500 and total assets were $40,050.
The following shows your calculation of ROA:
Net income ÷ Total assets = Return on Assets
$4,500 ÷ $40,050 = 11.2%
You calculation shows that your company made 11.2 percent on each dollar of assets it held.
ROA can vary significantly depending on the type of industry in which you operate. For example, if your business requires you to maintain lots of expensive equipment, such as a manufacturing firm, your ROA will be much lower than a service business that doesn’t need as many assets.
ROA can range from below 5 percent for manufacturing companies that require a large investment in machinery to as high as 20 percent or even higher for service companies with few assets.
Return on Equity
To measure how successful your company was in earning money for the owners or investors, calculate the Return on Equity (ROE) ratio. This ratio often looks better than Return on Assets because ROE doesn’t take debt into consideration.
You calculate ROE by dividing net income by shareholders’ or owners’ equity. (You find equity amounts on your balance sheet.) Suppose your company’s net income was $4,500 and the owners’ equity was $9,500.
Here is the formula:
Net income ÷ Shareholders’ or owners’ equity = Return on Equity
$4,500 ÷ $9,500 = 47.3%
Most business owners put in a lot of cash up front to get a business started, so it’s fairly common to see a business whose liabilities and equities are split close to 50 percent each.