Most small business people would agree that their Profit and Loss account (now more correctly called a Statement of Financial Performance) is among the easier \u2013 if not the easiest \u2013 financial document to understand. It\u2019s typically presented in two parts.<\/p>\n
The top half of the statement reveals the various sources of income the business has received for the period covered, such as a quarter, half year or full financial year. After subtracting the cost of producing your goods or services, it shows your gross profit figure.<\/p>\n
The bottom half of the account lists all the relatively fixed running costs (business overheads) such as rent, power and communication costs you need to pay each month regardless of sales levels. When these costs are subtracted from the gross profit the result is a net profit figure (before tax).<\/p>\n
So far, so simple, but you can learn more.<\/p>\n
These two results enable you to work out two key performance indicators (KPIs) that offer important insights into how your business is performing.<\/p>\n
The first, your gross profit margin, is the gross profit expressed as a percentage of sales.<\/p>\n
To work this out (if your accounting software doesn\u2019t do this automatically), you divide the gross profit figure by the sales total and multiply by 100 to get the percentage.<\/p>\n
Here\u2019s an example:<\/p>\n
Gross profit: $80,000<\/p>\n
Sales: $400,000<\/p>\n
GP %: 80,000 divided by 400,000 = 0.2 x 100 = 20%<\/p>\n
Multiplying by 100 allows you to study the gross profit margin as a percentage, so you can easily compare this result with previous margins, irrespective of fluctuating costs or sales levels. Has the margin improved? If not, it\u2019s time to investigate the causes. For instance, has there been an increase in the cost of materials or production labour?<\/p>\n
You can now compare your gross margin to similar businesses, because turning the result into a percentage overcomes any differences in size. Regardless of whether they are smaller or much larger businesses, it\u2019s the gross profit percentage (GP %) that tells the performance story.<\/p>\n
Depending on which sector you operate in, we can help find the average GP percentage for your industry. Your aim should then be to at least equal the industry average, and preferably do even better. You can also aim to improve on your previous gross margin results.<\/p>\n
The net profit margin reveals how profitable your business is when your overhead costs are deducted from the gross profit. It\u2019s worked out using a similar formula. For example:<\/p>\n
Net profit: $50,000<\/p>\n
Sales: 300,000<\/p>\n
NP %: 50,000 divided by 300,000 = 0.166 x 100 = 17%<\/p>\n
This KPI empowers you to spot trends before they become disasters. If your net profit margin has fallen, you need to dig for the causes. For example, you may find your marketing costs have blown out with no increase in sales. The lesson here would be to measure your marketing and advertising to see what is actually working, so you can drop any unproductive tactics.<\/p>\n