Profitability Ratios: Definition, Calculators, Formulas, Examples, and More

What Are Profitability Ratios?

Profitability ratios are financial metrics that evaluate a business’s financial health in terms of profit relative to other variables such as gross profit, assets, and equity during a given period.

In other words, the profit ratio indicates the portion of each dollar of sales above the cost of goods sold and how efficiently a business turns spending into profit.

Pro Tip: Utilizing a profitability ratio calculator can streamline this evaluation process for your business’s financial health. More on that later.

Pro Tip: Compare profitability ratios to historical data, competitors, or industry benchmarks for meaningful assessment.

What Are The Different Types of Profitability Ratios?

Profitability ratios fall into two categories: margin ratios and return ratios.

1. Margin Ratios

Margin ratios measure a company’s ability to turn sales into profit. These ratios compare revenue to metrics like:

• Gross profit
• Operating profit
• Net profit

The formula for margin ratios is your chosen profit metric divided by revenue.

2. Return Ratios

Return ratios measure a company’s ability to generate returns for its shareholders. Common return ratios include:

• Return on assets (ROA)
• Return on equity (ROE)
• Return on capital employed (ROCE)

What Is a Good Profitability Ratio?

Higher profitability ratios are an indication of efficiency while low profitability ratios suggest a business:

• Is not making the most of its available resources
• Does not represent a wise investment
• Is not currently operating in a sustainable or competitive way

However, it is possible to generate big profits with low profit ratios and sometimes it is necessary to operate with poor profitability ratios in the short term in order to achieve efficiency in the long term. Always assess profitability ratios within context and alongside other financial metrics like revenue trends and leverage ratios.

How to Calculate Margin Ratios

Here are five of the most common profitability ratios.

1. Gross Profit Margin

Gross profit is the revenue left over after you subtract the cost of goods sold (COGS) i.e. the direct costs involved in producing the goods that a business sells. COGS can be found on a business’s income statement.

The gross profit margin ratio compares gross profit to revenue. It tells you what percentage of revenue is left after direct operating costs have been covered.

A high gross margin ratio means a business has runway to cover general expenses, like insurance and marketing, and still make a profit. It is a sign of efficiency.

A low gross profit margin ratio, on the other hand, suggests a high cost of goods sold which means it will be difficult for the business to cover general expenses and still generate profit.

This could indicate poor sales, strong competition, or disadvantageous purchasing arrangements. It is a warning sign that the business may not be sustainable in its current state.

2. Operating Profit Margin

Operating profit, also known as EBIT or operating income, is the income generated by a business’s core operations before the deduction of interest and taxes. It appears on a company’s income statement.

Unlike gross profit, which only accounts for the direct cost of producing goods, operating income accounts for all operating expenses e.g. rent, administrative expenses, and managerial salaries.

Operating profit margin compares operating profit to revenue.

It is the percentage of total revenue remaining after COGS and operating expenses have been paid. Because operating profit accounts for more costs than gross profit, operating profit margin should be a smaller figure than gross margin.

A higher operating profit margin suggests a business:

• is operating efficiently
• is better placed to meet financial obligations
• could offer lower prices than their competitors
• is more resilient to economic shocks

3. EBITDA Margin

EBITDA stands for earnings before interest, taxes, depreciation, and amortization. This variable does not appear on a company’s financial statements but can be calculated using the formula:

EBITDA = EBIT (i.e. operating profit) + depreciation and amortization (D&A)

Like the gross profit and operating profit margins, the EBITDA margin measures a company’s profitability from operations.

However, EBITDA margin is the preferred tool for comparing the operating performance of two or more companies. This is because depreciation varies depending on the value of a company’s fixed assets which can obscure a fair comparison.

4. Net Profit Margin

Net profit (also referred to as net income) is a business’s income after all expenses have been subtracted.

This is the ‘bottom line’ on the income statement, the portion of sales that can be reinvested in the business or shared amongst the owners. The formula for net income is total revenue minus total expenses.

The net income margin ratio is a more stringent measure of a company’s profitability because it measures the business’s ability to generate revenue while accounting for all expenses.

However, it is not the best metric to use when comparing companies because it includes lots of potentially distracting variables.

Businesses with high net profit margin ratios can make good profits at a smaller scale whereas a business with a low net profit margin ratio must generate sales on a large scale to earn big profits.

Business operators can improve their net profit margin ratio by improving margins i.e. increasing prices or lowering operating costs.

This may increase total revenue.

However, you can also increase your revenue by bringing in new business and making more sales. This strategy will improve profitability but will not shift your net profit margin ratio. The right strategy depends on your unique business.

5. Cash Flow Margin

Cash flow is the money that moves in and out of a business during a given period. It is calculated by subtracting total cash outflow from total cash inflow. Well-managed cash flow is essential to the survival of a business because you need cash in hand to:

• pay expenses
• avoid late debt payment fees
• take advantage of opportunities

Consider the advantage of being able to access bulk purchase discounts or lower interest expenses because you can put up more money upfront. On the other hand, if your sales are poor and you have negative cash flow, you could struggle to pay debts and end up insolvent.

Cash flow margin compares cash flow to revenue. It measures how much of a business’s sales revenue is converted into cash. The higher the cash flow margin, the more cash a business is generating relative to sales. This is a sign of good financial health.

How to Calculate Return Ratios: The Easy Way

Return ratios tell us how well a company is using investment to generate wealth for its shareholders. Here are the formulae for three important profitability ratios in this category along with what they signal.

Already know what you’re doing and just want to skip to our profitability ratio calculators? Just scroll down and get calculating.

1. Return on Assets (ROA)

Return on assets is an indication of how effectively a company is using assets (e.g. machinery, intellectual property, or real estate) to generate income.

It is calculated by dividing net income by total assets. ROA helps answer the question, “Was x asset a good investment and are we making the most of it?”.

A low ratio suggests assets are under-performing. This metric is most useful for asset-intensive companies such as utility companies, streaming platforms, or car manufacturers.

3. Return on Equity (ROE)

Shareholder equity is the value of the assets owned by shareholders after all liabilities are settled. It can be described as the total amount of ownership investment in a company.

ROE expresses the relationship between income and equity.

It measures how effectively a business uses equity to generate income. A high ROE will attract investors because it indicates a high return on investment while a low ROE signals inefficient use of shareholder capital and poor returns.

3. Return on Capital Employed (ROCE)

Capital employed is the total amount of capital used by a business to generate profits.

Capital can be used to pay for land, equipment, software, or other investments that translate into income. Capital employed is calculated by subtracting current liabilities from total assets.

ROCE demonstrates the relationship between invested capital and EBIT. A high ROCE indicates that a business does a good job of generating profits from capital.

This metric is best for comparing companies in capital-intensive industries such as the airline or mining industries.

Profitability Ratio Calculators

If you just want to get to calculating your profitability ratios and don’t want to work through all the math, you’re in luck. Just plug in your data into the fields in our profitability calculators below and hit calculate!

Return on Assets (ROA) Calculator

Return on Equity (ROE) Calculator

Profitability Ratio Calculation Examples

JLR is a UK-based car manufacturer. We can find the following data in the company’s financial statements.

Using this data we can make the following calculations.

Both the operating margin and EBITDA margin have improved which suggests improved operating efficiency. Although the company’s net income was negative in both years (i.e. JLR made a loss), ROE and ROA made significant improvements.

This signals that JLR made better use of its assets and equity.

Cash flow margin took a dip which raises a red flag but it appears that JLR invested cash to improve their other profitability margins. This could be part of a long-term strategy to become profitable.

3 Important Tips for Evaluating Profitability Ratios

Like any form of analysis there are right ways to calculate and evaluate profitability ratios and many more wrong ways. Here are a few important tips to keep in mind:

1. Choose the right ratio. Some profitability ratios are better suited to certain purposes or industries. Speak to your accountant to determine the ratio that will provide the most useful insight or show off your business’s strengths.
2. Compare apples with apples. The best way to assess a profitability ratio is to compare it to a) historical data for the same company, b) a competitor’s profitability ratio, or c) an industry benchmark. This will tell you whether a business’s performance is improving or deteriorating and how it is performing relative to its peers.
3. Go beyond the ratios. Profitability ratios can be deliberately manipulated to mislead investors, miscalculated due to human error, or distorted by short-term factors. Always look at financial ratios alongside other KPIs, such as customer satisfaction, and qualitative data, like the quality of a company’s management team, to get the full picture.

What Are the Most Crucial Profitability Ratios?

Profitability ratios encompass various metrics, but some key ones include gross profit margin, operating profit margin, net profit margin, return on assets (ROA), return on equity (ROE), and return on capital employed (ROCE).

These ratios provide insights into different aspects of a company’s profitability, such as its ability to generate profit from sales, manage expenses, and utilize its assets and equity effectively.

Why Are Profitability Ratios Important?

Profitability ratios are crucial because they offer valuable insights into a company’s financial health and performance.

By assessing how effectively a company generates profits relative to its revenue, assets, and equity, profitability ratios help stakeholders understand the company’s operational efficiency, management effectiveness, and overall profitability.

They are essential for making informed decisions regarding investments, operations, and strategic planning.

How Is Business Profitability Best Measured?

Business profitability is best measured through a combination of profitability ratios tailored to the specific needs and goals of the company.

By analyzing various ratios such as:

• gross profit margin;
• operating profit margin;
• return on investment.

Businesses can gain a comprehensive understanding of their financial performance.

Additionally, utilizing profitability ratio calculators can streamline the measurement process, providing accurate and efficient assessments of profitability.

Raw Profit Isn’t Everything: Maximize Potential with Profitability Ratios

The golden rule of business is to bring in more money than you spend.

But profit is not just about the bottom line. It’s also about realizing as much value as possible from your available assets.

Understanding profitability ratios helps you identify inefficiencies, highlight red flags, and discover missed opportunities so you can grow your business and keep your investors happy.