The Key Financial Ratios for Interpreting Your P&L Statement

Let’s be honest, most small business owners feel like financial statements are hieroglyphics. They are told that these are important statements for interpreting how healthy their business is, but whenever they stare at this sheet of paper, they say to themselves, “Uhhhh…”

But business owners need to know how to digest this information! This is especially true for the Profit & Loss (P&L) Statement. The P&L statement stands as a cornerstone document for evaluating a company’s performance over a specific period in time. In order to help business owners use this information to make constructive decisions, CFOs (Chief Financial Officers) use ratios. These ratios offer invaluable insights into different aspects of a company’s operations, efficiency, profitability, and overall financial standing. There are lots of ratios to create, but here are some of the most frequently used ratios for deciphering the health of your business.

Gross Profit Margin

= Total Sales – Cost of Goods Sold (COGS)

The Gross Profit Margin is a fundamental metric that assesses the profitability of a company’s core business activities. It represents the percentage of revenues used to fund the direct costs of what your business provides. So if you are a plumbing company, it addresses how much your revenues goes towards field labor, subcontractor help and the materials used on jobs. A higher gross profit margin signifies efficient cost management and a healthy margin to cover operating expenses and generate profits. For example, a typically healthy, gross profit margin is 50% or greater.

Net Profit Margin

= Total Sales – COGS – Operating Expenses

Unlike the Gross Profit Margin, which focuses solely on production costs, the Net Profit Margin provides a holistic view of a company’s profitability. It factors in all expenses, including operating costs, taxes, interest, and other miscellaneous expenditures, to determine the percentage of revenue that translates into net profit. It’s essentially answering the question, “How much is leftover after all expenses are accounted for?”

PS – This is mostly true. The net profit margin is not a direct correlation with how much money you have in your bank account right now! For more on this, you will need to look at your balance sheet.

Operating Expense Ratio

= Total Operating Expenses / Total Sales

The Operating Expense Ratio evaluates a company’s efficiency in managing its operating expenses. This ratio highlights the proportion of revenue consumed by the indirect costs of the day-to-day operations, such as salaries (for administrators, owners and sales positions), rent, utilities, and marketing expenses. A lower operating expense ratio suggests effective cost control and operational efficiency. For instance, you ideally want your overhead to consume no more than 20% of your total sales.

Sales to Payroll Ratio

= Total Payroll / Total Sales

The Sales to Payroll Ratio measures the effectiveness of a company in utilizing its workforce to drive revenue generation. Many people have different interpretations of what a “healthy” ratio looks like for payroll. Generally, if you find that your staff takes more than 33% of your total sales, you likely have much more staff than is potentially required to handle your sales. Or, you just need to drive more sales into the door for your staff.

Sales to Materials Ratio

= Total Materials / Total Sales

For most companies, materials and supplies are used to get the work done! For plumbers, you have pipes and toilets and other parts. For restaurants, you have drinks and various food expenditures. All of these goods that help you deliver your products to customers are part of COGS (Cost of Goods Sold). So for specifically materials and supplies, it’s good to understand how much of your sales are going towards 

Sales to Advertising and Marketing Ratio

= Total Advertising and Marketing Expense / Total Sales

Every business should spend money on advertising and marketing. While some businesses brag about never needing to advertise for their business, a wise business owner will ensure that they are working on various ways to continuously generate more business. In each industry, there are certain standards for how much a conservative business spends, or an aggressive business spends on marketing. While some companies find 3% to 5% of sales enough for sufficient marketing expenses, others will spend 33% or more on marketing!

All of these ratios boil down to a simple question, “How well are you financially doing in your business?” And instead of just looking at a P&L statement and scratching your head about where the problems are in your business, you can use these ratios to determine where you need to focus your efforts to effectively make your business more profitable and grow it further than ever before!

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