Is your business really making a profit?
Simply looking at gross sales is a mistake many business owners make, but this is not enough to figure out if it is paying off. When you own a business, you must analyze several profitability ratios to see where your business is succeeding and where improvements need to be made.
In this article, we’ll help you understand ALL profitability ratios and how to calculate them. Plus, we’ll give you some tips on how to improve your profit margins.
What Are Profitability Ratios?
Profitability ratios are financial tools that reveal how well a company is generating revenue comparing different areas of the business, such as operating costs, profits, assets on the balance sheet, shareholders’ equity, cash flow, and taxes. Some profitability ratios should be as high as possible, while others should stay low.
You can think of profitability ratios like health measures, such as 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 important to compare profitability ratios only against businesses in the same industry. Typically, one industry will see vastly different numbers than a different industry.
Profitability ratios are measured over a certain time, such as weekly, monthly, quarterly, or annually. Calculating them this way helps you to see how your business performed within a timeframe.
Different Types of Profitability Ratios
There are two basic categories of profitability ratios: margin ratios and return ratios.
- Margin ratios simply measure a company’s ability to generate profits from sales.
- Return ratios, as the name implies, measure the ability of the business to generate and return wealth to stockholders.
Here’s a chart that shows eight of the most commonly used profitability ratios, divided into these two broader categories:
You can see the two categories, and which ratio is part of which category. Now, let’s take a detailed look at each ratio and its formulas.
Profitability Ratios Formulas
Here you will find a description of what each ratio is and its formula.
1st Ratio: Gross Profit Margin
The gross profit margin 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 is capable of paying its bills while still managing to make a profit.
Note that you’ll multiply by 100 (not by 100%) to arrive at a percent. And make sure you don’t use net profit in this equation!
To use an 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%.
2nd Ratio: EBITDA Margin
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 that can be used to compare businesses across industries.
3rd Ratio: Operating Profit Margin
The third ratio examines earnings while adding in depreciation and amortization, which are excluded in EBITDA margin. Operating profit margin shows the likelihood that a business can make it through a recession and compete with industry rivals.
4th Ratio: Net Profit Margin
The fourth ratio considers taxes and interest—plus all other expenses. The net profit margin divides net income by revenue. It’s a sort of “bottom line” of how a business has performed over a period of time. The disadvantage of the ratio is that because it includes all expenses, one-time outflows during the period have to be considered.
5th Ratio: Cash Flow Margin
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 is able to generate a lot of cash from a given amount of sales. A negative figure means that a business is losing money.
The numerator of the equation, cash flows, can be found with this equation:
6th Ratio: Return on Assets
We need a measure of how well a business is doing, not relative to cash flow or earnings, but assets on the balance sheet. Introducing return on assets, which does just that. This ratio varies widely from industry to industry, because some types of companies will naturally have more assets than others.
7th Ratio: Return on Equity
The seventh relationship is income versus shareholders’ equity. This ratio is often used by investors and stock analysts. It shows how well a business is using the money given to it by shareholders.
You can multiply the result by 100 to get a percentage if desired.
8th Ratio: Return on Invested Capital
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.
Ideally, ROIC is greater than 2%. NOPAT can be calculated with this equation:
EBIT is simply earnings before interest and taxes.
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. You could do the following:
- Hire an accounting firm to perform an audit. When you see the details on paper, you’ll be able to find expenses that can be reduced.
- Update your business plan. A business plan should be updated periodically. Doing so will help you see if your business is growing at a good rate and what new competition exists in the marketplace.
- Grow your company with a business loan. You could, for example, implement an advertising campaign to increase sales. That’s just one of the multiple ways you can grow your business with a business loan. Make sure to turn to a lender that understands your needs and goals, and that offers you the best possible rates.
Calculate Your Profits
The ability to use profitability ratios is of great importance when it comes to running a business. If you arrive at the conclusion that external funding could increase your business profitability and expand your company, consider a loan from Camino Financial.
Our business loan specialists will find the financing solution that best suits your needs and goals to maximize your return.