Small Business Accounting Guide

12. What you Should Know About Profitability Ratios

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Business Finance

What you Should Know About Profitability Ratios

Apr 20, 2023 • 9 min read
Woman uses calculator and graphs to calculate profitability
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      Financial metrics can provide valuable insight into the strength of your business’ financial position and performance. Profitability ratios are among the most important metrics, since maximizing profits is most businesses’ primary goal.

      Here’s what you should know about profitability ratios to use them effectively in your financial planning, including what they are, which ones are most common, and how to calculate them.

      What are profitability ratios?

      Profitability ratios are a type of financial metric that compares various line items on your financial statements to assess your earning capabilities. You can use them to analyze your business’ financial performance over an accounting period.

      However, profitability ratios typically don’t tell you much in isolation. Instead, they’re most beneficial when you compare them to ratios from previous periods or competitors in your industry. With that context, you can use them to inform your business decisions.

      How is a profitability ratio calculated?

      The formula for each profitability ratio is unique, but they never involve anything more complicated than addition and division. They’re ratios, after all, which measure the number of times one value fits into another.

      Typically, they involve comparing some measure of profit, like gross profit or net income, to gross revenue. However, some ratios also involve balance sheet accounts, such as assets or shareholders’ equity.

      What are the main types of profitability ratios?

      The two primary types of profitability ratios are margin and return ratios. Here are some commonly used examples, the formulas to calculate them, and a brief explanation of why they matter.

      Margin ratios

      Margin ratios usually only involve line items from the income statement. They help you analyze your company’s ability to turn revenue into profits. Generally, a higher margin ratio indicates higher efficiency.

      Here are some of the most common profitability margin ratios.

      Gross profit margin

      The gross profit margin captures the percentage of revenue retained after paying your cost of goods sold (COGS), which refers to the expenses necessary to make your product ready for sale. Typically, that includes direct materials, direct labor, and manufacturing overhead.

      Here’s the formula for the gross profit margin: Gross Profit Margin = (Revenue – Cost of Goods Sold) ÷ Revenue.

      Businesses often use the gross profit margin to determine whether their prices and COGS are reasonable for their industry. If yours is significantly lower than your competitors’, you probably need to raise your prices or reduce production costs.

      EBITDA margin

      EBITDA stands for earnings before interest, taxes, depreciation, and amortization. As you can probably infer, the EBITDA margin presents your net income as a percentage of your revenue, excluding your interest, taxes, depreciation, and amortization costs.

      Here’s the formula for the ratio: EBITDA Margin = (Net Income + Interest + Taxes + Depreciation + Amortization) ÷ Revenue.

      The EBITDA margin can be a helpful lens into your business’ performance because it removes the effects of external factors that might obscure your operation’s financial performance, such as your financing choices, depreciation and amortization recognition, and tax environment.

      Operating profit margin

      The operating profit margin tells you what percentage of revenue you retain after deducting all expenses related to your operations. That includes COGS and selling and administrative expenses, but excludes interest and taxes.

      Here’s the formula for the operating profit margin: Operating Profit Margin = Operating Income ÷ Revenue.

      The operating profit margin is also referred to as the earnings before interest and taxes (EBIT) margin. Like the EBITDA margin, it removes some of the factors that aren’t directly related to your operation. In this case, that’s your financing costs and tax burden.

      Net profit margin

      The net profit margin is sometimes called the return on sales ratio. It tells you what percentage of your revenue remains after all your costs, including COGS, operating expenses, and income taxes.

      Here’s the formula for the ratio: Net Profit Margin = Net Income ÷ Revenue.

      The net profit margin is the ultimate measure of your business’ profitability. The higher you raise the ratio, the more lucrative your business is.

      In addition, you can compare it to profitability ratios that include fewer expenses to gauge the impact those costs have on your profitability. For example, the difference between your operating and net profit margins tells you how significantly interest and taxes impact your profits.

      Return ratios

      Return ratios typically help you assess how effectively your business uses its assets to generate a return for its investors. The formulas use line items from your balance sheet and your income statement.

      Here are the two most commonly used return ratios.

      Return on assets

      The return on assets metric provides insight into how profitable your business is compared to its assets. Its assets include all the resources your company owns with positive economic value.

      Here’s the formula for the metric: Return on Assets = Net Income ÷ Total Assets.

      The return on assets ratio can help you determine how effectively your business uses its assets to generate a return for its owners. The higher it is, the better.

      Meanwhile, a low return on assets ratio may indicate that the business manager is using the company’s assets inefficiently or has purchased assets that aren’t beneficial.

      Return on equity

      The return on equity ratio is another profitability metric designed to assess how effectively you utilize your resources to generate profit. In this case, you’re looking at your profitability as a return on your equity, instead of your assets.

      Here’s how you calculate the ratio: Return on Equity = Net Income ÷ Total Equity.

      Your return on equity can be a valuable metric to demonstrate how effectively your business utilizes contributions from your investors. A high ratio may help you win additional financing.

      Who uses profitability ratios?

      Profitability ratios can be helpful to anyone interested in using your business’ financial statements to analyze its financial performance. As a business owner, you’ll likely use them to gauge your success, inform your business decisions, and find opportunities to improve your income.

      In addition, lenders and investors may also calculate these profitability ratios to determine whether they’re interested in working with you. As a result, they can affect your ability to qualify for financing.

      Which is the best measure of profitability?

      Ultimately, your net profit margin is probably the best measure of your business’ profitability, since it calculates the percentage of revenue kept as profit after you’ve paid all of your company’s expenses.

      However, it’s usually not the most practical tool for informing decisions on its own. You’ll typically need to analyze it alongside your other profitability ratios to understand how each group of expenses impacts your profits.

      About the author
      Nick Gallo, CPA

      Nick Gallo is a Certified Public Accountant and content marketer for the financial industry. He has been an auditor of international companies and a tax strategist for real estate investors. He now writes articles on personal and corporate finance, accounting and tax matters, and entrepreneurship.

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