Key Profitability Ratios for your Business
What are profitability ratios?
Profitability ratios are financial metrics used to measure a business’s ability to generate profits relative to its revenue, assets, and equity. These ratios are important indicators of a business’s financial health and performance and are used by investors to assess a business’s profitability and potential for growth.
These ratios can be used to compare a business’s performance to its competitors, industry benchmarks and averages, or historical performance.
What are margin profitability ratios?
Margin profitability ratios are financial metrics used to measure a company’s ability to generate profit relative to its revenue and expenses. These ratios can provide insights into a company’s operating efficiency and profitability.
By analyzing these margin profitability ratios, investors and analysts can gain insights into a company’s financial health and make informed investment decisions. We explore some of these ratios below.
Gross Profit Margin
This ratio measures the percentage of revenue that remains after deducting the cost of goods sold in the business. A high gross profit margin indicates that a company is generating a healthy profit on its products or services.
It is an important financial metric that helps businesses assess their profitability and efficiency in managing their production costs.
Gross profit margin formula
The gross profit margin formula is:
Gross Profit Margin = (Revenue – Cost of Goods Sold) / Revenue
Operating Profit Margin
Operating profit, also known as Earnings Before Interest and Taxes (EBIT), is calculated by subtracting the operating expenses from the gross profit. Operating expenses include items such as salaries, rent, utilities, and marketing expenses.
It is a key metric for evaluating a company’s profitability and efficiency in generating profits from its operations.
Operating profit margin formula
The operating profit margin formula is:
Operating Profit Margin = Operating Profit / Revenue
By dividing the operating profit by the revenue, the operating profit margin measures the percentage of revenue that remains after deducting the operating expenses.
Net Profit Margin
This ratio measures the percentage of revenue that remains after deducting all expenses, including taxes and interest. It provides an overall picture of a company’s profitability.
A higher net profit margin indicates that the company is able to generate more profit from its revenue, which is generally considered a positive sign.
Net profit margin formula
The formula for calculating the net profit margin is:
Net Profit Margin = (Net Profit / Total Revenue) x 100%
By showing the net profit margin as a percentage, it allows for easier comparison between companies of different sizes and in different industries.
This ratio measures a company’s earnings before interest, taxes, depreciation, and amortization (EBITDA) as a percentage of revenue. It is often used to compare the profitability of companies in the same industry.
EBITDA margin formula
The formula for calculating EBITDA margin is:
EBITDA Margin = (EBITDA / Total Revenue) x 100%
To calculate the EBITDA margin, you divide EBITDA by total revenue and then multiply the result by 100% to express it as a percentage. The EBITDA margin is a useful metric for evaluating a company’s operating profitability because it excludes the effects of financing and accounting decisions, which can vary widely between companies.
Return profitability ratios are financial metrics used to measure a company’s ability to generate profits relative to its investment or capital structure. These ratios are important because they help investors and analysts understand how efficiently a company is using its resources to generate profits.
Overall, these ratios are important for investors and analysts to assess the profitability and efficiency of a company, and can be used to compare a company’s performance to its peers or industry standards. As with above, we explore some of these ratios below.
Return on assets
ROA is a financial ratio that measures a company’s profitability by expressing its net income as a percentage of its total assets. It shows how efficient a company is at using its assets to generate profits. A higher ROA indicates that the company is generating more profit per dollar of assets.
Return on assets formula
The return on assets (ROA) formula is:
ROA = Net Income / Average Total Assets
Return on equity
Return on Equity (ROE): This ratio measures the amount of net income a company generates as a percentage of its shareholders’ equity. It indicates how effectively the company is using its shareholders’ investments to generate profits.
Return on equity formula
The return on equity (ROE) formula is calculated by dividing net income by shareholders’ equity:
ROE = Net Income / Shareholders’ Equity
Return on capital employed
Return on Capital Employed (ROCE) is a financial ratio that measures the efficiency and profitability of a company’s capital investments. It indicates how well a company is using its capital to generate profits. A higher ROCE indicates that the company is generating more profits per unit of capital employed, while a lower ROCE indicates the opposite.
Return on capital employed formula
The formula for Return on Capital Employed (ROCE) is:
ROCE = EBIT / (Total Assets – Current Liabilities)
How to use profitability ratios in your business
There are many different uses for profitability ratios within a business. In fact, you’ll likely find that these will at some point be essential to you for your growth.
Assess your financial health
By calculating profitability ratios, you can assess your business’s financial health and determine if it is generating sufficient profits to sustain operations, pay off debt, and invest in growth opportunities.
Compare your performance
You can use profitability ratios to compare your business’s performance against industry benchmarks, competitors, or historical data. This can help you identify areas where your business is excelling or failing, in which case adjustments can be made.
Evaluate pricing strategies
Profitability ratios can help you evaluate the impact of pricing strategies on your bottom line. For example, you can calculate your gross profit margin to determine if your pricing is generating sufficient profits after accounting for the cost of goods sold.
Monitor operational efficiency
Profitability ratios can also help you monitor the efficiency of your business operations. For example, you can use the asset turnover ratio to determine how effectively you are using your assets to generate revenue, or the return on investment ratio to assess the profitability of your investments.
Overall, profitability ratios can be a valuable tool for assessing your business’s financial performance, identifying areas for improvement, and making informed decisions about pricing, investments, and operations. It’s important to note that profitability ratios should be used in conjunction with other financial metrics and factors, such as cash flow, liquidity, and risk, to get a more complete picture of your business’s financial health.
What is a good profitability ratio?
A good profitability ratio is typically one that indicates a company is generating healthy profits relative to its revenue or assets. Overall, a good profitability ratio will depend on the industry and market conditions, but higher ratios are generally better than lower ones. It’s also important to compare a company’s profitability ratios to its peers and industry benchmarks to get a better sense of how it is performing.
Examples of profitability ratios
In this example we display the return on equity (ROE) ratio.
Let’s say a company has a net income of $10 million and its shareholders’ equity is $100 million. The ROE would be 10%, calculated as:
ROE = (Net Income / Shareholders’ Equity) x 100%
ROE = ($10 million / $100 million) x 100%
ROE = 10%
This means that for every dollar of shareholder equity, the company generated 10 cents of profit.
Investors and analysts often use ROE to evaluate a company’s profitability and its ability to generate returns for its shareholders. They may compare the ROE of a company to others in the same industry to determine if it is performing well or poorly in comparison. Additionally, they may track changes in ROE over time to assess the company’s long-term profitability and potential for growth.
Why are profitability ratios important?
Here are some reasons why profitability ratios are important:
Measure of success
Profitability ratios are a key indicator of a company’s success. They help determine whether the company is making a profit or operating at a loss.
Comparison with industry standards
Profitability ratios allow companies to compare their financial performance with industry benchmarks, which helps identify areas for improvement.
Investors are interested in companies that can generate consistent profits. Profitability ratios help investors evaluate a company’s potential for growth and profitability.
Guide for decision-making
Profitability ratios can help management make informed decisions about pricing strategies, cost-cutting measures, and investments.
Profitability ratios can indicate a company’s financial stability and sustainability. A company with consistently high profitability ratios is more likely to be financially stable and sustainable in the long term.
Profitability ratios are important for assessing a company’s financial health and potential for growth. By analyzing these ratios, companies can make informed decisions that lead to increased profitability and financial stability.
Using financial modelling for profitability tracking
Financial modelling tools can be used for profitability tracking. Brixx’s financial modelling software involves creating financial projections and forecasts based on the information you input about your business performance. These projections can be used to track the financial health of a business and identify opportunities to improve profitability.
There are various types of financial models that can be used for profitability tracking, including:
Profit and loss (P&L) model
The profit and loss model tracks the revenues, costs, and expenses of a business over a specific period, such as a quarter or a year. It can be used to identify areas where the business is generating profits and areas where it is incurring losses.
Cash flow model
This model tracks the inflows and outflows of cash in a business over a specific period. It can be used to identify cash flow gaps and opportunities to improve cash flow, which can ultimately impact profitability. We have a handy free cash flow forecasting template available for download.
This model calculates the minimum level of sales a business needs to generate to cover its costs and break-even. It can be used to identify the level of sales needed to achieve profitability and the impact of changes in pricing or costs on profitability.
Get started FREE with Brixx today
and take the first steps to planning your business’ future developmentStart your free trial