You must analyze several profitability ratios to see where your business is succeeding and where you need to make improvements. Simply looking at gross sales is a mistake many business owners make.
In this article, we’ll help you understand important profitability ratios and how to calculate each one. Plus, we’ll give you some tips on how to improve your profit margins.
What Are Profitability Ratios?
Profitability ratios are financial metrics that reveal how well a company generates revenue.
They compare different areas of the business, such as:
- operating costs
- balance sheet assets
- shareholders’ equity
- cash flow
Some profitability ratios should be as high as possible, while others should stay low.
You can think of profitability ratios as health measures like blood pressure, pulse, or temperature. Once you have these numbers, you’ll know if your business is overall healthy or not.
In most cases, it’s essential to compare profitability ratios only against businesses in the same industry.
Typically, one industry will see vastly different numbers
than another one.
You can measure profitability ratios weekly, monthly, quarterly, or annually. Calculating them helps you see how your business performed within a specific timeframe.
How Profitability Ratios Help Your Business
Profitability ratios help business owners manage their business better to realize more profit.
By using a mix of ratios, you can measure your business's financial success and keep it on a sustained growth trajectory
. Moreover, by doing so, you see how well your company performs in the marketplace.
#DidYouKnow These ratios include actual, historical data you can review and analyze.
It's a good idea to calculate your company's quarterly and annual profitability. Comparing data in each quarter helps you strategize the best ways to manage your business's operations.
Profitability ratio data shows what areas of your business thrive or need improvement.
For instance, a business's sales may be on the rise, but expenses keep the operating profit too low. This makes it harder to stay competitive in their industry. A business owner can make financial corrections to improve their company's financial health.
Profitability ratios help improve a company's performance and make changes to operations.
But they're also critical financial metrics used by investors.
#DidYouKnow Banks, lenders, stockholders, and venture capitalists use financial ratios to determine a company's profitability and potential growth. // They can predict a company's financial stability and future success by reviewing a business's accounting history.
Different Types Of Profitability Ratios
There are 3 basic categories, each one with different profitability ratios.
||They simply measure a company’s ability to generate profits from sales.
- Gross profit
- Earnings before interest, taxes, depreciation, and amortization
- Cash flow
- Net profit
- Operating profit
||As the name implies, they measure the ability of the business to generate and return wealth to stockholders.
- Return on assets
- Return on equity
- Return on invested capital
|Cash flow ratios
||They measure how much cash is available and accessible in real-time. Surplus or deficit ratios indicate whether there's a shortfall or surplus of money on hand after paying current liabilities.
- Cash flow margin ratio
- Net cash flow ratio
#DidYouKnow You could use all this information to make a business profitability analysis.
Revenue vs Profit
Profitability Ratios Formulas
If you want to learn how to measure profitability, here you will find the most important ratios, their descriptions, and their formulas.
Formula for Gross Profit Ratio
The gross profit ratio shows how well a business is doing relative to the cost of paying for the business’s operations.
You want the ratio to be as high as possible. A high number demonstrates that a business can pay its bills while still managing to make a profit.
Gross profit margin = [ ( Revenue - Cost of goods sold ) / Revenue ] x 100
Note that you’ll multiply by 100 to arrive at a percent.
For example, let’s say your business has $90,000 in revenue, and COGS (cost of goods sold
) is $70,000. The gross profit margin is 22.2%.
#CaminoTip Don't confuse gross profit, net profit, and operating profit
EBITDA Margin Formula
This profitability ratio takes EBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortization) and compares it to gross revenue
It’s one of the few ratios you can use to compare businesses across industries.
EBITDA margin = ( EBITDA / Revenue ) x 100
Operating Profit Margin Formula
The third ratio examines the company's earnings while adding depreciation and amortization, which the EBITDA margin excludes.
Operating profit margin shows the likelihood that a business can make it through a recession and compete with industry rivals.
Operating profit margin = ( Operating profit / Revenue ) x 100
Net Profit Margin Formula
The fourth ratio considers taxes and interest—plus all other expenses. Then, it divides net income by revenue.
The net profit margin shows how a business has performed over a period; it’s a sort of “bottom line.”
The disadvantage of the ratio is that you have to consider one-time outflows during the period because it includes all expenses.
Net profit margin = ( Net income / Revenue ) x 100
Cash Flow Margin Formula
This number reveals how capable a business is to take revenue and turn it into cash
A high cash flow margin shows that a business can generate a lot of cash from a given amount of sales. Conversely, a negative figure means that a company is losing money.
Cash Flow Margin = ( Cash flows / Revenue ) x 100
You can find cash flows with this equation:
Cash flows = Net Income + Depreciation + Amortization + Change in Working Capital
Return On Assets Ratio Formula
Return on assets measures how well a business is doing, not relative to cash flow or earnings, but assets on the balance sheet.
This ratio varies from industry to industry because some types of companies will have more assets than others.
Return on assets = ( Net income / Assets ) x 100
Return On Equity Formula
The seventh relationship is income versus shareholders’ equity.
Investors and stock analysts often use this ratio. It shows how well a business uses the money given to it by shareholders.
Return on equity = ( Net income / Shareholders' equity ) x 100
You can multiply the result by 100 to get a percentage if desired.
Return On Invested Capital (ROIC) Formula
To include the funds provided by bondholders, we have the eighth and final ratio: return on invested capital.
This figure tells you how much money a business makes beyond the average cost for equity and debt capital.
ROIC = ( Net operating profit after tax / Invested capital ) x 100
Ideally, ROIC is greater than 2%.
You can calculate net operating profit after tax (NOPAT) with this equation:
NOPAT = EBIT x ( 1- tax rate )
EBIT is simply earnings before interest and taxes.
Cash Flow Margin Ratio Formula
The net result of this ratio indicates a company's financial stability within a given period.
This ratio helps a small business owner determine the best time to take out a loan. Likewise, investors also scrutinize a business's cash flow margin ratio when considering which companies to invest in.
The formula is simple but provides quick information to assess a business's profitability.
Operating margin = Operating income/Revenue
When using this formula, remember that a business's operating income represents the amount of realized profit after deducting costs and expenses.
Additionally, revenue reflects how much income a company generates by selling goods and services before subtracting expenses.
Net Cash Flow Ratio Formula
Also referred to as the net profit margin ratio, small business owners use this ratio to analyze the total net income generated.
Net profit margin = Revenue - (Cost / Revenue )
After making the calculation, the results are a percentage of actual revenues a business receives.
That number provides an overall picture of a business's financial health, indicating whether there's a cash surplus or deficit. In other words, the measurement reflects what percentage of revenue you generate as profit.
Profitability Ratios: An Example
A manufacturing company we'll call ABC Razor Company struggles to stay afloat. Some months, they end up with a surplus of money, while other times, there's a clear deficit.
The business owner reviews his financial statements regularly, but he can't achieve sustained growth for his company no matter what he does. Therefore, he seeks the services of an accountant.
The accounting professional uses these profitability ratios to access where the business owner needs to make changes.
Gross Profit Margin
The ratio shows that the ABC Razor Company's profit margin is 8% which varies each quarter. This is because costs of sales steadily increase while the revenue stays the same.
This indicates that to realize a higher profit ratio, the business owner must:
Net Profit Margin
- increase revenue
- decrease costs of sales
To see how well the company operates over time, the accountant discovers that the ABC Razor Company pays too much interest, further reducing net profit.
The accountant suggests that the business owner consolidate his loans to make one payment and reduce the total interest paid.
Cash Flow Margin
The accountant sees a financial pattern and uses this formula to confirm their suspicions: the company's negative cash flow indicates that the company is losing money.
They encourage the business owner to:
Operating Profit Margin
- receive more timely payments from customers
- review and revise his credit terms policy
- renegotiable accounts payable terms with vendors
- sell unused inventory
They can determine how efficiently the business converts actual sales to cash. How? By viewing cash as a percentage of revenue in a select timeframe.
The business owner needs to:
- increase pricing
- reduce expenses
- find better ways to market his goods to create brand awareness
Tips To Improve Your Profitability Ratios
- Review your operation to determine which products and services perform the best. If a particular one routinely falls behind in sales, consider rebranding it or eliminating it.
- Make sure you don't overspend. Always use a budget to keep spending on track. Reduce spending further by exploring different buyer options with vendors and supplies. Relocate to a less expensive location.
- Increase your operation's efficiency. Take a close look at how you conduct your operation across the board. Spot weak areas and make course corrections. Communicate with employees, customers, and suppliers, and find ways to maximize cash flow.
- Keep an eye on your inventory. A bloated inventory reduces your available cash flow, takes up space you can use for something else (or lease the unused space), and takes extra time to maintain and monitor.
- Consider raising the prices of goods and services. Customers expect a modest price increase every so often.
- Develop a new line of goods or services. You can realize a boost in sales by offering benefits. Initially, your research and development budget will take a hit, but the right product or service could catapult revenue.
- Expand your market to new locations. Keeping existing customers and finding new ones grows your business. You may need to increase capital with a loan, hire more employees, or include a second location.
Go A Step Further With Financial Modeling
Financial modeling enables a business owner to make current and future financial predictions.
You can prepare these models using software programs such as MS Excel. People calculate them based on past financial performance records of a business.
For example, financial institutions, accountants, and business owners can prepare a basic financial model. They use historical data such as:
- income statement
- balance sheet
- cash flow statement
- charts and graphs
- other documents
From there, you can prepare more complex models for further cash flow analysis to make strategic acquisitions and investments.
Business owners access the information on financial models to make decisions when:
- raising capital
- purchasing or selling available assets
- expanding goods and services to other markets
- predicting growth
- valuing a business to sell it
How To Improve Your Profit Margins
Once you know your profitability ratios, you’ll want to develop strategies to improve your business’s profit margins
. For example, you could do the following:
If you need external funding to increase your profitability, consider a small business loan.
- Hire an accounting firm to perform an audit. Then, when you see the details on paper, you’ll find expenses that you can reduce.
- Update your business plan. You should revise your business plan should periodically. Doing so will help you see if your business is growing reasonably and what new competition exists in the marketplace.
- Grow your company with a business loan. You could grow your business with a commercial loan. Make sure to turn to a lender who understands your needs and goals and offers you the best possible rates.
Our business loan specialists will find the financing solution that best suits your needs and goals to maximize your return.
How to calculate profitability?
There are multiple ways to calculate profitability. The most common method is to use profitability ratios, which compare the company's revenue and expenses.
What are the 10 profitability ratios?
- gross profit margin
- EBITDA margin
- operating profit margin
- net profit margin
- cash flow margin
- return on assets
- return on equity
- cash flow margin ratio
- return on invested capital
- net profit margin ratio
How is a business’s profitability calculated?
Profitability ratios show how different numbers interact with each other to generate profit or loss. The numbers used are:
- cost of goods sold
- earnings before interest
- depreciation and amortization
- operating profit
- net income
- cash flow
- shareholders' equity
- invested capital
What are good profitability ratios?
A higher overall profitability ratio or profit margin between 10% to 20% usually indicates that a business has positive revenue, income, and cash flow values.
What do profitability ratios measure?
They measure a company's ability to realize a profit based on its overall performance and potential to generate revenue.
How to improve the profitability ratio of a company?
- Monitor where and how much money you spend.
- Eliminate products and services that don't sell.
- Watch inventory levels.
- Increase prices slightly.
- Run your business more efficiently.
- Create a new product or service.
- Expand to a second location.