How Much Profit Should a Small Business Make?

A small business should make at least 10% in profits from its gross revenue. An excellent profit margin is 30% of gross revenue.

By Douglas Wade, Attorney

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Table of Content

1. How to Define a Profit Margin

2. Formula for Profit Margins

3. What is a Suitable Profit Margin?

4. Online Calculators

5. Additional and Useful Company Performance Metrics

6. Business Lawyers You Can Trust

How to Define a Profit Margin

In the fields of finance and accounting, a profit margin is defined as an accurate measure of a business’s earnings or profits. Importantly, this is relative to its revenue. There are three central profit margin metrics:

Net Profit Margin: This includes revenue minus all expenses, such as interest as well as taxes.
Gross Profit Margin: This includes the total revenue of the business if you subtract the cost of goods that are sold.
Operating Profit Margin: This includes the total revenue minus goods that are sold as well as the business’s operating expenses.

It is essential to be aware of how profit margins work and can impact your business. Being familiar with these formulas and understanding the examples we go over here will lead to a greater understanding of your own business profits.

Formula for Profit Margins

There are three major margin ratios to consider when assessing a company’s profitability: net, operating and gross. Here are how the three categories can be broken down:

Net Profit Margin: Net income is divided by revenue times 100 (Net Income/Revenue X 100)
Operating Profit Margin: Operating profit is divided by revenue times 100 (Operating Profit/Revenue X 100)
Gross Profit Margin: Gross profit is divided by revenue times 100 (Gross Profit / Revenue x 100)

Generally, the difference between net and gross is significant, and usually, your gross margin will be much larger than the net margin. Here is an example of driving these formulas home.

Example

ABC Sneaker Company does its business online, selling custom sneakers to a niche market. In 2021, the revenue created by selling this premium footwear was $700,00 annually. Now, the cost of producing the sneakers for the business (known as the cost of goods sold or COGS) is $200,000 annually. All of the additional expenses (taxes and interest paid, administrative, selling costs, and general costs) add up to $400,000.

Here is how you would calculate the net and gross profit margins for ABC Company in 2021.

Income Statement:

$700,000 revenue
$200,000 cost of goods sold
$500,000 gross profit
$400,000 other expenses
$100,000 net income

According to the income statement figures above, the answers are:

Net margin is $100k of net income divided by $700k of revenue, which is equal to 14.3%.

Gross margin equals $500k of gross profit divided by $700k of revenue, which gives you 71.4%.

What is a Suitable Profit Margin?

Now that you understand how to calculate your company’s profit margins, what numbers should you be aspiring to? Margins that are considered “good” vary by industry; however, generally, we consider a 10% net profit margin to be average, a 20% net profit margin to be considered suitable or “high,” and a 5% profit margin to be considered low.

It is important to note that these guidelines vary widely by company size and industry. They are also subject to a variety of other factors, so consider them approximate, and perhaps do some research into the appropriate or “good” profit margins in your business industry.

Online Calculators

When you are ready to work on calculating the profit margins for your business, there are a wealth of Excel calculators (some are free, some charge a modest sum) online. Using these calculators, you will be able to input various assumptions over periods of years. After entering in values for revenue, cost of goods sold, and other expenses, you will find out your company’s approximate and predicted margins for gross and net profits. You may also see the acronym EBIT in use; this simply stands for “earnings before interest and taxes.”

Additional and Useful Company Performance Metrics

When you are analyzing a business, it is useful to not only look at the obvious numbers. In fact, an excellent analyst will survey a range of financial metrics, ratios, and other important measures of company performance. Below, you will find a list of performance metrics used by expert analysts in the field. Just as understanding profit margins is an important aspect of your business knowledge, understanding how these metrics can be used can also help you make sense of the numbers and run a more profitable business.

Additional performance metrics include:

The Internal Rate of Return (IRR)
The Revenue Growth Rate
The Return on Assets (ROA)
The Return on Equity (ROE)
The Net Present Value (NPV)
The Dividend Yield
The Cash Flow Yield

Deciding which financial metrics are the most essential for your business is an ongoing process, one that is dependent on your industry and the very nature of your company. For example, Business ABC may find that an analysis of their Revenue Growth Rate helps them understand their sneaker business. Business XYZ, however, has found that studying their Return on Equity has helped their company succeed and become more viable and profitable. It is a good idea to experiment until you find out what works for your specific company, in your specific sector and industry.

One more tip: the metrics that usually become the most important for a business are the metrics that reveal a performance rate that is significantly different than that of other similar companies. We hope that through considering the factors we touched on in this article and computing your own profit margins, you will not only be more aware of your business numbers but be headed down the road to business success in the future.

Business Lawyers You Can Trust

Business lawyers can help clarify aspects of profit margins that remain complicated. At Nakase Wade, we offer free consultations, and our attorneys work with many small businesses. If you need assistance, please contact us today.

Have a quick question? We answered nearly 2000 FAQs.

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