What You Should Know About Profitability Ratios

Any business, no matter the size, is concerned with profitability. In the majority of cases, you want to be turning as big a profit as possible—and if your business isn’t profitable, you’ll probably want it to turn a profit soon. Although there are examples of massive corporations that stay unprofitable for years—tech giants like Amazon and Uber are some famous instances—profitably is a top concern for most small businesses.

Profitability ratios allow you to measure the profitability of your enterprise. There are several methods to measure how much profit you’re earning. These formulas generally measure your revenue against expenses over a specified period of time.

How Is a Profitability Ratio Calculated?

Your profitability ratio will depend on how you want to measure your company’s profitability. Generally, you’ll want to compare your profit and revenue, but you might also opt to take your shareholders’ equity, assets, and cash flow into consideration.

Importantly, calculate and track your profitability ratio over time. You can also compare this ratio with business forecasts or industry norms.

What Are the 3 Main Profitability Ratios?

There are 3 main groupings of profitability ratios that are generally accepted in small business accounting: margin ratios, return ratios, and cash flow ratios. They differ in how they define profit. It is best to calculate ratios using several different methods to get a holistic picture of your company’s financial health.

1. Margin Ratios

Margin ratios define profit as the revenue remaining after expenses are deducted. The types of margin ratios are defined by what expenses they consider.

Net Profit Margin

Net profit margin is often called the “bottom line” of your company—it shows how much revenue you keep after deducting a large array of your expenses.

To calculate your net profit margin, you first determine your operating profit. Operating profit is a company’s total revenue minus operating expenses, such as labor, rent, and cost of goods sold (COGS).

Subtract tax and interest expenses from your operating income—this is your net profit.

Net profit margin = Net profit / Revenue

The result will be a decimal expression of your net profit margin percentage.

Operating Profit Margin

Operating profit takes most day-to-day expenses into consideration, but not interest or taxes. You can compare operating profit margin and net profit margin to see how much interest and tax is impacting your profitability.

Remember, operating profit is your revenue minus operating expenses, but not taxes or interest.

Operating profit margin = Operating profit / Revenue

The result will be a decimal expression of your operating profit margin percentage.

2. Return Ratios

Instead of looking at revenue, return ratios define profitability based on how well a company turns investments, like shareholder capital, into profit. These formulas look at entries from your balance sheet as well as your income statement.

Return on Equity

Return on equity (RoE) considers how much money a company earns compared to how much money was invested into it by shareholders. RoE shows how much profit a company turns per dollar invested.

RoE = Net profit / Shareholder equity

The result will be a decimal expression of your RoE percentage. Shareholders often like this method because it shows directly how a company is managing their investment.

Return on Assets

Return on assets (RoA) showcases how well a company is utilizing its assets, like vehicles, real estate, intellectual property, or machinery, to turn a profit.

RoA = Net profit / Total assets

The result will be a decimal expression of your RoA percentage.

3. Cash Flow Ratios

Cash flow profitability ratios define profitability as how well your company turns revenue into cash. Furthermore, a cash flow ratio shows if your business is amassing a cash surplus or running at a deficit. Over time, running a business with a negative cash flow can lead you into a cash crunch.

Cash Flow Margin Ratio

The cash flow margin starts with your net profit and adds in non-cash expenses, like depreciation or amortization, as well as changes in working capital, which is how money moves between your debtors and shareholders.

Cash flow margin = (Net profit + Non-cash expenses + Changes in working capital) / Revenue

The result will be a decimal expression of your cash flow margin percentage.

Who Uses Profitability Ratios?

Investors, lenders, banks, and shareholders will all look at your profitability ratio when deciding to approve your company for financing or investment.

Most importantly, you should pay close attention to your profitability and track it over time.

What Is the Best Measure of Profitability?

Net profit margin is probably the most popular way to express profitability. Potential lenders and investors will pay close attention to this number. However, the different methods are all important—each one drills down on your profitability based on different variables.