Finance for non-finance people in easy words
Everything I learnt the hard way made easy for you
In 2018, when I embarked on my entrepreneurship journey, dealing with financials was a daunting challenge for me, given my background in Philosophy. Numbers seemed entirely incomprehensible. Despite this, I am known for my tenacity, and so I made a firm decision to master financials.
Over the years, I diligently learned from the fundamentals to the complexities of financial management, recognizing that it was essential for effectively running my business. I delved into cash flow, margins, ratios, terminology, strategies, and systems.
Having chosen the challenging path myself, I realized that others shouldn't have to face the same difficulties. Therefore, I have compiled a series of articles covering both basic and advanced financial topics, aiming to help business owners navigate their financial endeavors with ease.
🌱 In this one I am going to speak about:
what is gross profit margin, how to calculate it, and why it is important
what is net profit margin, how to calculate it, and why it is important
👉 What is Gross Profit Margin
The gross profit margin is a crucial metric that indicates the percentage of revenue that remains after deducting the direct costs associated with producing goods or delivering services. It helps business owners assess how efficiently they are using their resources.
Gross Profit Margin = ((Gross Profit / Total Revenue) * 100%)
To calculate the gross profit margin, you'll need to know two key figures:
Gross Profit: This represents the total revenue generated by the business minus the cost of goods sold (COGS). COGS includes all the direct costs associated with producing goods or delivering services, such as raw materials, manufacturing costs, and direct labor.
The formula for calculating gross profit is:
Gross Profit = Total Revenue - Cost of Goods SoldTotal Revenue: This is the total income generated by the business from sales or providing services. It includes all the revenue received from customers before deducting any expenses.
Once you have the values for Gross Profit and Total Revenue, you can calculate the Gross Profit Margin using the formula mentioned above. The result will be a percentage that indicates the portion of each dollar of revenue that represents gross profit.
💥 Example:
Let's say a company's total revenue for a particular period is 500,000 euros, and its cost of goods sold is 250,000 euros. To calculate the gross profit margin:
Gross Profit = 500,000 - 250,000 = 250,000
Gross Profit Margin = (250,000 / 500,000) * 100% = 50%
In this example, the company's gross profit margin is 50%, meaning that for every dollar of revenue earned, 50 cents represent gross profit after deducting the direct costs of producing goods or services.
🔥 Why it’s important to know the Gross profit Margin?
Well, according to the author Greg Crabtree in his book "Simple Numbers, Straight Talk, Big Profits!" the gross profit margin is a crucial financial metric for several reasons:
Profitability Assessment: It provides a clear indication of how efficiently a business is producing goods or delivering services.
A higher gross profit margin indicates that the business is generating more revenue relative to its direct costs of production, which is a positive sign of profitability.
Cost Control: Monitoring the gross profit margin helps business owners identify opportunities for cost control.
By understanding the relationship between revenue and the cost of goods sold, they can make informed decisions to optimize production processes, negotiate better deals with suppliers, or adjust pricing strategies to improve profitability.
Pricing Strategy: It is a critical factor when setting prices for products or services.
Business owners need to ensure that the pricing structure allows them to maintain a healthy gross profit margin while remaining competitive in the market.
Business Performance Benchmarking: Comparing the gross profit margin to industry benchmarks or historical data helps business owners assess how well their company is performing relative to competitors or past performance.
It provides insights into the company's competitive position and overall financial health.
Cash Flow Management: Maintaining a healthy gross profit margin contributes to a positive cash flow.
Adequate gross profits enable businesses to cover operating expenses, invest in growth opportunities, and service debt obligations.
Investor and Lender Confidence: Investors and lenders often consider the gross profit margin as an important factor when evaluating the financial health and sustainability of a business.
A healthy margin reassures them that the company has a viable business model and is generating enough revenue to cover its direct costs.
Growth and Expansion: A strong gross profit margin allows businesses to reinvest in the company's growth and expansion.
It provides the financial resources needed to invest in marketing, research and development, and infrastructure improvements.
In conclusion, it serves as a foundational metric for understanding the fundamental financial health of the business and guides decision-making across various aspects of operations and strategy.
👉 What is Net Profit Margin
The net profit margin is the percentage of revenue that remains after all expenses, including operating expenses, taxes, and interest, have been deducted. It reflects the company's overall profitability.
The net profit margin is a financial metric that measures the profitability of a business by determining the percentage of each dollar of revenue that represents the company's net profit after all expenses have been deducted. It is a key indicator of how effectively a company manages its costs and generates profit from its core operations.
The formula for calculating the net profit margin is as follows:
Net Profit Margin = ((Net Profit / Total Revenue) * 100%)
Where:
Net Profit refers to the total profit remaining after all expenses, including operating expenses, interest, taxes, and other non-operational items, have been deducted from the total revenue.
Total Revenue is the total income generated by the business from sales or providing services before any deductions.
💥 Example:
Let's say a company's total revenue for a specific period is 500,000 euros, and after deducting all expenses (including operating expenses, interest, and taxes), its net profit is 50,000 euros. To calculate the net profit margin:
Net Profit Margin = ($50,000 / $500,000) * 100% = 10%
In this example, the company's net profit margin is 10%. This means that for every dollar of revenue earned, the company keeps 10 cents as net profit.
A higher net profit margin generally indicates that the business is operating efficiently and generating healthy profits from its core operations.
However, it's important to interpret net profit margins in the context of the industry, company size, and other relevant factors for a meaningful assessment of the business's financial performance.
🔥Why it is important to know the net profit margin?
Knowing the net profit margin is crucial for business owners because it provides valuable insights into the overall financial health and profitability of the company.
Again, according to the author Greg Crabtree in his book "Simple Numbers, Straight Talk, Big Profits!" the net profit margin is important for several reasons:
Performance Evaluation: The net profit margin serves as a key performance indicator (KPI) for the business.
By monitoring this metric over time, business owners can evaluate the effectiveness of their strategies, cost management efforts, and revenue generation.
Cost Management: Understanding the net profit margin allows business owners to identify areas where cost control and efficiency improvements are needed.
By analyzing expenses and operational inefficiencies, they can take corrective actions to increase profitability.
Pricing and Sales Strategies: The net profit margin influences pricing decisions and sales strategies.
By knowing the profitability of different products or services, business owners can adjust prices or focus on high-margin offerings to boost overall profitability.
Financial Health: A healthy net profit margin indicates that a business is generating sufficient profits to cover all expenses, including operating expenses, interest, taxes, and other non-operational costs.
It is an important factor in attracting investors, lenders, and potential business partners.
Competitive Benchmarking: Comparing the net profit margin with industry benchmarks and competitors' performance provides valuable insights into how the business stacks up against its peers. It helps identify areas for improvement and best practices to emulate.
Strategic Planning: The net profit margin plays a pivotal role in strategic planning and goal setting.
It provides a foundation for establishing financial targets and defining the company's vision for growth and profitability.
Cash Flow Management: A positive net profit margin contributes to a positive cash flow, which is essential for meeting financial obligations, reinvesting in the business, and maintaining financial stability.
In conclusion, by understanding and monitoring the net profit margin, business owners can make data-driven decisions, adapt their business strategies, and ensure their companies remain competitive and financially successful in the long run.
In general, I consider both metrics to be highly significant, as they provide valuable insights into our business's performance and highlight areas that require attention, improvement, or investment.
To obtain these metrics, it's essential to maintain well-organized spreadsheets with meticulous records of sales, expenses, and cost of goods/services.
In my upcoming article, I will share the fundamentals of cash flow tracking and provide a comprehensive guide to common business expenses.
If there are any specific aspects you would like me to analyze further, please let me know, and I'll be glad to include them in the article.
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