Learn how to calculate the right ratios to measure profitability for you and your investors.
Measuring your business’s financial performance is crucial when it comes to managing your expenses and increasing profitability. But there are so many different metrics to monitor success. It can be overwhelming.
In this article, you’ll learn the basics about profitability ratios, why they matter, and which ones matter most. After reading, you can expect to know:
- Which profitability ratios you need for your business and how to calculate them
- The importance of profitability ratios and how they can help your business
Let’s dive in.
Table of Contents
What Are Profitability Ratios?
Profitability ratios measure your company’s ability to earn a profit. It takes into account sales revenue as well as things like operating expenses (OPEX), balance sheet assets, and shareholders’ equity.
And if you have shareholders, profitability ratios will show how well you use existing assets to generate profit and value for them, too.
Margin Ratios vs. Return Ratios—Know the Difference
There are two categories of profitability ratios: margin ratios and return ratios. Margin ratios represent the ability to turn sales dollars into profits. Return ratios illustrate the company’s ability to generate shareholder and owner wealth.
Within these two categories of profitability ratios, there are 5 ratios that are most essential for most businesses. As you become more familiar with these ratios, you can start expanding and adding more profitability ratios to the mix.
Margin Ratios You Should Track
The 3 margin ratios that are crucial to your business are gross profit margin, operating profit margin, and net profit margin.
Ratio #1: Gross Profit Margin
Gross profit margin is the most widely used margin ratio. It calculates the amount left over after covering cost of goods sold (CoGS). The numbers needed to calculate this ratio are found on your business’ income statement.
A high gross profit margin reflects a high efficiency of earning revenue and covering business expenses, taxes, and depreciation.
gross profit margin = (total sales – cost of goods sold) ÷ total sales
Ratio #2: Operating Profit Margin
The operating profit margin, also known as earnings before interest and taxes (EBIT), looks at earnings as a percentage of sales before deducting interest and taxes. It is calculated by taking your gross profit and subtracting operating costs—these expenses usually include rent, utilities, salaries, administrative and general costs.
Your operating profit margin is a widely used assessment tool to determine how well your business can adapt to a slowdown. It can also determine profitability for seasonal businesses—when profits may decrease, but you may still need to cover operating expenses.
operating profit margin = operating profit ÷ revenue
Ratio #3: Net Profit Margin
Net profit margin shows how much your business makes in profit after all expenses (both operating and non-operating) are paid.
A high net profit margin is an indication that your company is successfully operating and generating income—this means you’re excelling at managing costs and pricing your goods or services.
Here is the calculation for the net profit margin. Again, your income statement will provide the figures needed for this formula:
net profit margin = net income ÷ revenue
Return Ratios You Should Track
The 2 return ratios that are crucial to your business are return on assets and return on equity. These determine how much profit you are generating for owners and/or shareholders.
Ratio #4: Return on Assets
Return on assets (ROA) focuses on the efficiency of using assets to generate profitability. This is valuable information as it informs the business how well it uses its resources and assets to generate a profit.
Here is a simple formula for return on assets:
return on assets = net income ÷ total assets
Ratio #5: Return on Equity
Return on equity is a critical ratio for shareholders and investors in the business. It measures the return on investment that investors have put into the company, which can be useful when trying to gain new investors. Again, the figures needed for this formula come from the income statement.
return on equity = net income ÷ average shareholder’s equity
3 Ways to Use Profitability Ratios in Your Business
Your company’s profitability is probably always at the top of your mind. Measuring current and past profitability helps you project growth and future profitability.
When looking at your profitability ratios, you’ll want to compare them with averages for companies within the same industry and to your own historical data.
Following are three important reasons to calculate and track your profitability ratios.
1. Evaluate Your Company’s Performance Over Time
Analyzing profitability ratios annual or quarterly brings visibility into how your business is performing. Comparing these ratios over a period of time helps inform future strategies and can also be used to explain years where financial performance was poor. This is especially important as businesses start to bounce back from the COVID-19 pandemic.
For example, about 40% of construction firms were forced to lay off staff due to the lack of demand for projects. This likely affected their expenses and sales revenue. However, now that the world is opening up, and construction sites are reopened, there is growth that many firms are experiencing.
Being able to measure these effects is crucial for assessing a company’s financial health and evidence of post-pandemic growth.
2. Expose Areas of the Business That Need Improvement
Numbers themselves don’t tell a story, but data with a story does. Tying your income statement and balance sheet into meaningful ratios helps uncover areas of your business that are excelling and needing improvement.
For example, a marketing agency may have an instance where they’re gaining more clients than ever before. However, when analyzing their profitability ratios, they realize that the operating profit margin is low, but the gross profit margin is healthy. These ratios reveal to the marketing agency that although they are increasing sales, the operational expenses to manage those new clients are high.
The following steps could further evaluate the different administrative costs to see where the operating ratio can be lowered.
3. Find Investors
Investors want to know how profitable a company is and its capability to handle expenses. They also want to know its financial history to ensure that there is evidence of growth or that the company is on the trajectory of growth.
Financial ratios predict financial stability and generate profit after all costs are covered, so presenting the five financial ratios listed above is a simple way to provide evidence of this.
Key Takeaway—Profitability Ratios are Essential for Your Business
Managing business finances can be cumbersome, on top of trying to achieve and maintain profitability. But as we learned, profitability ratios are beneficial when measuring success and uncovering areas of your business that need attention. They are also crucial when looking for additional investments.
Remember, there are only 5 main ratios that you must be measuring:
- Gross profit margin
- Operating profit margin
- Net profit margin
- Return on assets
- Return on equity
Use these profitability ratios to start effectively managing your business finances and well-being.