What category of ratios measures how efficiently a firm manages its assets and operations to generate net income?

The gross profit margin ratio compares the gross profit of your business to its total revenue to show how much profit your business is making after paying your cost of goods sold. This ratio shows the percentage margin between what you receive for your product or service and what it costs you in cost of sales. Your gross profit margin shows whether your sales are sufficient to cover your costs of goods sold.

It also allows you to compare your performance with other businesses, or over time, and is a good measure of how efficient your business is at converting products and services into revenue.

Formula: Gross profit margin (%) = (Gross profit ÷ Total revenue) x 100

Aim for: Your figure will depend on your industry or sector. For example, professional services might have 80% or higher, while manufacturing or construction industry might have between 45% and 60%.

Calculate gross profit margin

$$\text{Gross profit margin} = \frac{\text{Gross profit}}{\text{Total revenue}} \times 100$$

Brett's Bakery has a total sales revenue of $450,000. After subtracting the $300,000 cost of raw materials (e.g. flour, eggs, sugar) and wages directly involved in baking and selling the goods, the bakery has a gross profit of $150,000. Based on these sales and costs, they have a gross profit margin of 33.33%.

Determining your net profit ratio or net profit margin can help you make decisions related to your business, from pricing goods and services to opportunities for reinvestment. Net profit represents the amount of money your business has after your expenses are paid or accounted for. This can also be referred to as net income or net earnings.

Net profit is one way to get a sense of how profitable your business is. Additionally, you may want to consider looking into your gross profit, operating profit, and net profit.

Gross Profit Margin Ratio

Although gross margin ratios and net profit ratios are similar, there are some differences. While both are profitability ratios, gross profit shows the percentage of revenue that exceeds the cost of goods sold.

This ratio shows you the amount of money the business has on hand after subtracting the cost of goods sold. Both the net profit and gross profit formulas can be used to calculate net profit margin and gross profit margin.

Inventory Turnover Ratio

An inventory turnover or inventory turnover ratio refers to the rate at which inventory is being used or consumed over a period of time. As a business owner, this is a way to track how many times you are selling and replacing inventory in order to better forecast how much you might need. There are several ways you can calculate this ratio. Below is an inventory turnover formula to consider:

Using your balance sheet and income statement, you can identify your cost of goods sold number to use within the formula above. Keeping track of your inventory turnover ratio can help you see the ebbs and flows of inventory. This can help you better predict how much inventory to keep in stock over a particular period of time. An inventory turnover ratio may uncover that your business is holding inventory for too long, also known as obsolete inventory, or that a particular type of inventory is frequently out of stock. In the case of obsolete inventory, a business is holding on to inventory that it may not be able to use or sell due to a lack of demand. After a certain amount of time passes it goes from being slow-moving inventory to excess inventory before finally becoming obsolete.

Quick Ratio

A quick ratio, also known as an acid test ratio, is a way to measure your business’s liquidity. Business owners can use a quick ratio calculation to measure if the business can cover costs and make future payments. Here is a sample formula for calculating a quick ratio:

The assets in this formula are assets and cash the business has on hand that could be quickly converted into cash. Assets that can be easily converted to cash are also referred to as liquid assets. As you are calculating a ratio that factors in assets and liabilities, you can find the values for this ratio in your company’s balance sheet.

Debt-to-Equity Ratio

If you are a business with debt, a debt-to-equity ratio can help you see if your debt is high relative to your business. In this equation, debt represents all the liabilities your business owes to other businesses, employees, or the government and equity represents the ownership or value of your business. This is a way to assess if your business’s debt and equity could pose a financial risk to your business.

You can find your equity in your balance sheet or calculate it by subtracting your liabilities from assets. Debt is found by adding your long-term debt, short-term debt, and fixed payments.

These financial ratios are just a few to consider when looking to better measure your business’s profitability, cash flow, and efficiency. While one financial ratio alone can’t give you a complete picture of your business’s financial performance, uing these ratios can give you better awareness of potential opportunities.

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