Do you know what your company’s profitability ratios are? If you asked most business owners what their net earnings were last year, they could probably answer you immediately. But if you asked them what their profitability ratio was, you’d probably get a puzzled look. Many of them would be wondering, “What is a profitability ratio, anyway?”
Profitability ratios are financial measurements that tell you important information about how your business is performing. There are actually several different types of profitability ratios that show you different things about the state of your business finances. These include ratios that measure your profit margin against different benchmarks as well as ratios that tell investors what kind of return they can expect from their interest in your company. Knowing the profitability ratio definition for each of these types of measurements can help you manage your company’s finances more effectively as well as attract support from investors. Here’s what you need to know about how to define profitability ratio, what the different types of ratios are and how you can use them to grow your business, gain a competitive edge and attract investors.
What Are Profitability Ratios?
It will be helpful to start with a generic profitability ratio definition before getting into the details of specific ratios and their equations. A profitability ratio is a key performance indicator (KPI) that measures the financial performance of your business. Profitability ratios form one category of what accountants, financial analysts and investors refer to as financial ratios or accounting ratios. Other types of financial ratios measure variables such as:
- How much cash your company has available to pay its immediate debts (liquidity ratios)
- How much ability your company has to repay your long-term debt (leverage ratios)
- How efficiently your company uses financial resources (activity ratios)
- How much your company’s shares are earning (valuation ratios)
In contrast to these other financial ratios, profitability ratios measure your company’s performance in terms of profit, as expressed in a ratio comparing different variables. For this reason, financial ratios are also sometimes referred to as performance ratios.
What Are the Different Types of Profitability Ratios?
This preliminary definition gives you a general answer to the question, “What is a profitability ratio?” But to do a profitability ratios analysis,(2) you need to know the different types of ratios and the specific equations used to calculate them. As a starting point to more specifically define profitability ratio, there are two main subcategories of ratios:
- Margin ratios, which measure your company’s ability to transform raw sales revenue into profits
- Return ratios, which measure your company’s ability to generate returns for investors
To develop these distinctions into a practical profitability ratios definition that can be put to actual use, let’s first look more closely at margin ratios before going on to return ratios. There are many different ways to measure margins. Three particular profitability measures are widely used for margin measurements:
Gross Profit Margin (GPM)
This measures your profitability in terms of how much profit you retain from your net sales after covering the cost of goods and services sold. It tells you how well you’re controlling the cost of your operations and inventory. Gross profit margin is calculated by taking your gross profit (the profit you make after deducting the costs of producing and selling your products and services) and dividing it by your net sales (your gross sales minus returns, allowances and discounts). You can get your gross profit margin and your net sales from your income statement (also known as your profit and loss or P&L statement). The higher your gross profit margin, the more efficiently you are turning a profit and covering costs. On the other hand, the lower this margin, the higher your cost of goods and services sold, which can reflect factors such as low sales volume, low pricing of your products or high payments to suppliers.
Operating Profit Margin (OPM), or Earnings Before Interest and Taxes (EBIT, or EBITDA When Depreciation and Amortization Are Included)
This ratio measures your earnings before repaying business loans and paying taxes as a percentage of sales. This measures the efficiency of your operations at generating revenue before paying non-operating expenses such as interest and taxes. To calculate it, divide your EBIT by your net sales. You can get these figures from your income statement. The higher your operating profit margin, the less of your profit is going to cover operating expenses, while a low margin means you’re spending more money on operations.
Net Profit Margin (NPM)
This measures how much of your net sales you retain as income after all expenses are paid, including both operating and non-operating costs. To calculate it, divide your net income (your income after paying all operating, interest, tax and other expenses) by your net sales. You can get these figures from your income statement. A high net profit margin means more of your sales are left over for profit after covering all your expenses, while a low margin means that you have less profit on your bottom line.
Of these three ratios, net profit margin is most frequently used when doing a simple profitability analysis. There are also other margin ratios,(3) such as cash flow margin. However, gross, operating and net profit margin are the most commonly used margin ratios.
Common Return Ratios
In addition to margin ratios, there are return ratios which measure how well your business generates returns for investors. Where margin ratios are generated from your income statements, returns ratios also make use of information generated from your balance statements. Two return ratios are especially important and widely used:
Return on Assets (ROA)
This ratio compares your net income with your total assets. It measures how efficiently you are converting your assets, including debt from loans and equity from investors, into profits. To calculate it, you take your net income from your income statement and divide it by your total assets from your balance sheet. The higher your return on assets, the better you are using those assets—including loans and equity—to generate sales, while a lower number indicates that your assets are not being transformed into sales efficiently.
Return on Equity (ROE)
This ratio compares your net income with the amount of equity stockholders have invested in your company. It measures the return in profits that is being generated from stockholder investments. To calculate it, divide the net income from your income statement by your stockholders’ equity from your balance statement. The higher the ratio, the better use you are making of investors’ money, while a low ratio indicates their investments are not being used efficiently.
Return on equity is the most important financial ratio to stockholders since it tells them how much profit your company has available to distribute to them. There are also other return ratios, such as cash return on assets and return on invested capital. But return on assets and equity are the two most commonly used return ratios.
How to Leverage Profitability Ratios for a Business Advantage
There a few major ways you can apply profitability ratios to grow your business, gain an advantage on your competitors and attract investors:
- You can track your margin ratios over time to identify places where you could improve the efficiency of your profit generation. For instance, a low gross profit margin might draw your attention to a need to increase your sales activity, raise your prices or cut your logistics costs.
- You can compare your margin ratios with those of other companies in your industry or your industry as a whole, allowing you to see where you could improve to be more competitive. For instance, if you find you’re spending more on your operations than your competitors, or you’re paying about the same as your competitors, you might be able to gain a competitive advantage by upgrading your software or using an outsourcing strategy to cut costs.
- You can use good returns ratios to attract investors. Alternately, if you have poor returns ratios, you might seek to improve your returns by improving your margins ratios to make your company more appealing to investors.
The most efficient way to track and apply profitability ratios is to use a cloud-based app that syncs your accounting data with a dashboard displaying your ratios as KPIs. Your accounting provider and IT team can assist you in setting up automated tracking of your profitability ratios.
Profitability ratios are key performance indicators that let you measure how well your business is doing financially. Different ratios let you measure your profitability in terms of your gross profit margin, your operating margin, your net profit margin, your return on assets or your return on equity. Knowing these ratios can help you identify places where your company is making and losing money, as well as how appealing your company is to investors. This can help you manage your finances more efficiently, improve your profitability versus that of competitors and win support from investors.