Every firm is most concerned with its profitability. One of the most frequently used tools of financial ratio analysis is profitability ratios. They are used to determine the company's bottom line for its managers and its return on equity to its investors. Profitability measures are important to company managers and owners alike. Management has to have a measure of profitability in order to steer the business in the right direction. If a business has outside investors who have purchased stock in the company, the company management has to show profitability to those equity investors. Show Profitability ratios, as discussed and illustrated below, show a company's overall efficiency in using its assets and performance at the end of each quarter or year. Profitability ratios are divided into two types: margin ratios and return ratios. Ratios that show margins represent the firm's ability to translate sales dollars into profits at various stages of measurement. Ratios that show returns represent the firm's ability to measure the overall efficiency of the firm in generating returns for its shareholders.
Financial ratio analysis of any ratios is meaningless unless the manager has something to compare the ratios to. Managers generally use either trend or industry analysis. Trend analysis involves, in this case, looking at the business's profitability ratios over time and looking for positive and negative trends. Industry analysis is the comparison of a business's profitability ratios to those of other businesses in the same industry sector. The gross profit margin calculates the cost of goods sold as a percent of sales—both numbers can be found on the income statement. This ratio looks at how well a company controls the cost of its inventory and the manufacturing of its products and subsequently passes on the costs to its customers. The larger the gross profit margin, the better for the company. Calculate gross profit margin by first subtracting the cost of goods sold from sales. If sales are $100 and the cost of goods sold is $60, the gross profit is $40. Then divide gross profit by sales which would be: $40 / $100 = 40%. The gross profit margin, which is the amount of sales revenue that can be devoted to utilities, inventory, and manufacturing costs is 40% of sales. The operating profit is usually called earnings before interest and taxes or EBIT on a business's income statement. The operating profit margin is EBIT as a percentage of sales. It is a measure of a company's overall operating efficiency. It differs from the gross profit margin by further subtracting out the expenses of ordinary, daily business activity from sales. The operating profit margin is calculated using this formula: EBIT / Sales. If EBIT is $20 and sales are $100, then the operating profit margin is 20%. Both terms of the equation come from the company's income statement. When doing a simple profitability ratio analysis, the net profit margin is the most often margin ratio used. The net profit margin shows how much of each sales dollar remains as net income after all expenses are paid. For example, if the net profit margin is 5%, that means that 5 cents of every dollar of sales made are profit. The net profit margin measures profitability after consideration of all expenses including taxes, interest, and depreciation. The calculation is: Net Income / Net Sales =_%. Both terms of the equation come from the income statement. The cash flow margin ratio is an important ratio as it expresses the relationship between cash generated from operations and sales. The company needs cash to pay dividends, suppliers, service debt, and invest in new capital assets, so cash is just as important as profit to a business firm. The Cash Flow Margin ratio measures the ability of a firm to translate sales into cash. The calculation is Cash From Operating Cash Flows / Net Sales = _%. The numerator of the equation comes from the firm's Statement of Cash Flows. The denominator comes from the Income Statement. The return on assets ratio is an important profitability ratio because it measures the efficiency with which the company is managing its investment in assets and using them to generate profit. It measures the amount of profit earned relative to the firm's level of investment in total assets. The return on assets ratio is related to the asset management category of financial ratios. The calculation for the return on assets ratio is: Net Income / Total Assets = _%. Net income is taken from the income statement, and total assets are taken from the balance sheet. The higher the percentage, the better, because that means the company is doing a good job using its assets to generate sales. The return on equity ratio is perhaps the most important of all the financial ratios to a publicly-held company's investors. It measures the return on the money the investors have put into the company. It is the ratio potential investors look at when deciding whether or not to invest in the company. The calculation is Net Income / Stockholders Equity = _%. Net income comes from the income statement, and stockholder's equity comes from the balance sheet. In general, the higher the percentage, the better, with some exceptions, as it shows that the company is doing a good job using the investors' money. The cash return on assets ratio is generally used only in more advanced profitability ratio analysis. It is used as a cash comparison to return on assets since the return on assets is stated on an accrual basis. Cash is required for future investments. The calculation is Cash Flow From Operating Activities / Total Assets = _%. The numerator is taken from the Statement of Cash Flows and the denominator from the balance sheet. The higher the percentage, the better. There are many financial ratios—liquidity ratios, debt or financial leverage ratios, efficiency or asset management ratios, and profitability ratios—that it is often hard to see the big picture. You can get bogged down in the detail.
Financial managers must have a way to tie together the financial ratios and know where the profitability of the business firm is actually coming from. The DuPont Model can show a business owner where the component parts of the return of assets (or return on investment ratio) come from as well as the return on equity ratio. For example, did return on assets come from net profit or asset turnover? Did return on equity come from net profit, asset turnover, or the business's debt position? The DuPont model is very helpful to business owners in determining if and where financial adjustments need to be made. Scaling Your Business Measuring your business’s financial performance is crucial when it comes to managing your expenses and increasing profitability. But there are so many different metrics to monitor success. It can be overwhelming. In this article, you’ll learn the basics about profitability ratios, why they matter, and which ones matter most. After reading, you can expect to know:
Let’s dive in. Contents Profitability ratios measure your company’s ability to earn a profit. It takes into account sales revenue as well as things like operating expenses (OPEX), balance sheet assets, and shareholders’ equity. And if you have shareholders, profitability ratios will show how well you use existing assets to generate profit and value for them, too.  Margin Ratios vs. Return Ratios—Know the DifferenceThere are two categories of profitability ratios: margin ratios and return ratios. Margin ratios represent the ability to turn sales dollars into profits. Return ratios illustrate the company’s ability to generate shareholder and owner wealth. Within these two categories of profitability ratios, there are 5 ratios that are most essential for most businesses. As you become more familiar with these ratios, you can start expanding and adding more profitability ratios to the mix. Margin Ratios You Should TrackThe 3 margin ratios that are crucial to your business are gross profit margin, operating profit margin, and net profit margin. Ratio #1: Gross Profit MarginGross profit margin is the most widely used margin ratio. It calculates the amount left over after covering cost of goods sold (CoGS). The numbers needed to calculate this ratio are found on your business’ income statement. A high gross profit margin reflects a high efficiency of earning revenue and covering business expenses, taxes, and depreciation. gross profit margin = (total sales – cost of goods sold) ÷ total sales Ratio #2: Operating Profit MarginThe operating profit margin, also known as earnings before interest and taxes (EBIT), looks at earnings as a percentage of sales before deducting interest and taxes. It is calculated by taking your gross profit and subtracting operating costs—these expenses usually include rent, utilities, salaries, administrative and general costs. Your operating profit margin is a widely used assessment tool to determine how well your business can adapt to a slowdown. It can also determine profitability for seasonal businesses—when profits may decrease, but you may still need to cover operating expenses. operating profit margin = operating profit ÷ revenue Ratio #3: Net Profit MarginNet profit margin shows how much your business makes in profit after all expenses (both operating and non-operating) are paid. A high net profit margin is an indication that your company is successfully operating and generating income—this means you’re excelling at managing costs and pricing your goods or services. Here is the calculation for the net profit margin. Again, your income statement will provide the figures needed for this formula: net profit margin = net income ÷ revenue Return Ratios You Should TrackThe 2 return ratios that are crucial to your business are return on assets and return on equity. These determine how much profit you are generating for owners and/or shareholders. Ratio #4: Return on AssetsReturn on assets (ROA) focuses on the efficiency of using assets to generate profitability. This is valuable information as it informs the business how well it uses its resources and assets to generate a profit. Here is a simple formula for return on assets: return on assets = net income ÷ total assets Ratio #5: Return on EquityReturn on equity is a critical ratio for shareholders and investors in the business. It measures the return on investment that investors have put into the company, which can be useful when trying to gain new investors. Again, the figures needed for this formula come from the income statement. return on equity = net income ÷ average shareholder’s equity 3 Ways to Use Profitability Ratios in Your BusinessYour company’s profitability is probably always at the top of your mind. Measuring current and past profitability helps you project growth and future profitability. Following are three important reasons to calculate and track your profitability ratios. 1. Evaluate Your Company’s Performance Over TimeAnalyzing profitability ratios annual or quarterly brings visibility into how your business is performing. Comparing these ratios over a period of time helps inform future strategies and can also be used to explain years where financial performance was poor. This is especially important as businesses start to bounce back from the COVID-19 pandemic. For example, about 40% of construction firms were forced to lay off staff due to the lack of demand for projects. This likely affected their expenses and sales revenue. However, now that the world is opening up, and construction sites are reopened, there is growth that many firms are experiencing. 2. Expose Areas of the Business That Need ImprovementNumbers themselves don’t tell a story, but data with a story does. Tying your income statement and balance sheet into meaningful ratios helps uncover areas of your business that are excelling and needing improvement. For example, a marketing agency may have an instance where they’re gaining more clients than ever before. However, when analyzing their profitability ratios, they realize that the operating profit margin is low, but the gross profit margin is healthy. These ratios reveal to the marketing agency that although they are increasing sales, the operational expenses to manage those new clients are high. The following steps could further evaluate the different administrative costs to see where the operating ratio can be lowered.
3. Find InvestorsInvestors want to know how profitable a company is and its capability to handle expenses. They also want to know its financial history to ensure that there is evidence of growth or that the company is on the trajectory of growth. Financial ratios predict financial stability and generate profit after all costs are covered, so presenting the five financial ratios listed above is a simple way to provide evidence of this. Key Takeaway—Profitability Ratios are Essential for Your BusinessManaging business finances can be cumbersome, on top of trying to achieve and maintain profitability. But as we learned, profitability ratios are beneficial when measuring success and uncovering areas of your business that need attention. They are also crucial when looking for additional investments. Remember, there are only 5 main ratios that you must be measuring:
Use these profitability ratios to start effectively managing your business finances and well-being.
Megan Smith is a B2B marketer based in Toronto with experience in SaaS, e-commerce, and fin-tech industries. Megan creates content that educates, inspires, and drives revenue. |
Higher values indicate profitability in which of the following profitability ratios
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