There are numerous financial metrics you can use to monitor the success of your business. If you’re not currently tracking your company’s profitability ratios, you probably should be.
Read on for a breakdown of what profitability ratios are and how to calculate them. You’ll also discover why this information matters to your business’s cash flow in the first place.
What Are Profitability Ratios?
Profitability ratios measure a company’s ability to earn a profit relative to its sales revenue, operating costs, balance sheet assets, and shareholders’ equity. These financial metrics can also show how well companies use their existing assets to generate profit and value for owners and shareholders.
Types of Profitability Ratios
There are two types of profitability ratios — margin ratios and return ratios. The various types of calculations can help you measure your company’s financial health and financial performance in several ways.
Margin ratios examine how effectively a company transforms sales revenue into profits. Here’s a simple breakdown of three common margin ratios — gross profit margin, operating profit margin, and net profit margin. Understanding these ratios can help you gain control of your business’s cash flow.
Gross profit margin ratio
Gross profit margin is typically the first profitability ratio calculated by businesses. It measures how much sales income a company has left over after it covers the cost of goods sold (COGS). This figure is known as a company’s gross profit margin.
You can calculate your company’s gross profit margin with the formula below. The initial figures you need to complete the formula should be available on your business’ income statement.
Gross Profit ÷ Revenue (aka Net Sales) = Gross Profit Margin %
A higher gross profit margin indicates that you have more money left over to cover operating expenses, taxes, depreciation, and other business costs. It may also result in higher ending profits for owners and shareholders.
Operating profit margin ratio
Once you calculate your gross profit ratio, you can use the figure to help find your operating profit. Operating profit, or earnings before interest and taxes (EBIT), takes your gross profit and deducts operating expenses. These expenses may include commissions, administrative expenses, and other general costs.
A company’s operating profit reveals how much revenue is left over after it covers both COGS and operating expenses. The operating profit margin shows the percentage of revenue that remains once these costs are deducted from your net sales.
You can calculate your company’s operating profit margin using the formula below. Again, both initial figures you need for your calculations may appear on your company’s income statement.
Operating Profit ÷ Revenue (aka Net Sales) = Operating Profit Margin %
If your company shows a low operating profit margin (especially if your gross profit margin is healthy), it might be a sign that you’re spending too much on operating costs.
Net profit margin ratio
As a small business owner, the profitability measurement that may matter most to you is your company’s net profit margin ratio. It reveals how much of the money your company earns makes its way to the bottom line.
Specifically, net profit margin shows the percentage of profit your company keeps from its sales revenue after all expenses (operating and non-operating) are paid.
Here is the formula you can use to calculate your company’s net profit margin. Check your income statement for the initial figures you need to plug into the equation.
Net Income ÷ Revenue (aka Net Sales) = Net Profit Margin %
A high net profit margin typically indicates a company that is operating successfully. Your business is doing a good job managing costs and pricing its goods or services.
Return ratios show whether a business generates a profit for its owners or shareholders. Two of the most common return ratios that businesses calculate are return on assets (ROA) and return on equity (ROE).
Return on assets
Your company’s return on assets, also called return on investment, is all about efficiency. It indicates how good your company is at turning its investments into a profit. Put another way, ROA measures how successfully your company uses the assets at its disposal to improve its bottom line.
Financial managers may calculate ROA in a few different ways. A simple formula used to find your company’s return on assets is below.
Net Income ÷ Total Assets = Return on Assets %
A high ROA may indicate that your company can earn income efficiently using its available assets.
Return on equity
Investors in a business may be more concerned with return on equity calculations than other financial metrics. ROE shows how well a company can use shareholder investments to generate profits. It’s a measure of a shareholder’s return on his or her investment.
You can calculate a company’s return on equity using the formula below. The net income figure can be found on your income statement. Shareholder’s equity may be available on your company’s balance sheet.
Net Income ÷ Average Shareholder’s Equity = Return on Equity %
ROE is often used to evaluate company management. A low ROE may indicate that management is doing a poor job at using its investors’ funds to generate a return.
Why Profitability Ratios Matter
Every business is concerned with making a profit. As an owner or shareholder, the easiest way to tell if a company is generating a healthy bottom line is to review its profitability ratios.
Why are profitability ratios useful?
- Profitability ratios can attract new investors. Investors want to know that a company has the potential to turn a healthy profit before they invest any cash in it. Reviewing a company’s profitability ratios is a simple way to analyze whether a business is performing well in that area.
- You can compare your company’s performance with competitors. As a startup or small business, you might not earn the same amount of income as a more-established business in your industry. Your company’s earnings might not even be close. Yet by comparing profitability ratios (aka percentages), you can see how your business measures up to others. Earning less money than another company doesn’t automatically mean your business is less profitable.
- Financial ratios can help uncover areas in your business that need work. While it’s important to track your company’s basic financial statements, those numbers alone may not tell the whole story. When you add on profitability ratios, you can discover if your business performs with efficiency in specific areas. For example, if you find that your gross profit margin is decreasing over time, it could indicate that you need to get your cost of goods sold under control.
- You may get better loans. When you apply for small business loans, lenders may want to complete a financial analysis of your company to make sure you’re budgeting correctly and your cash flow is healthy. As a borrower, you’ll appear less risky if your business has good financial health — and often allows you to get lower interest rates and better terms for the loans you qualify for.
How to Improve Your Profitability Ratios
Profitability ratios can help you measure the financial well being of your company. If you don’t like the financial metrics these reports reveal, here are five strategies you can use to try to boost your company’s bottom line.
- Cut unprofitable services and products from your lineup. In general, it’s best to focus on the services and products that generate the highest profits for your business.
- Reduce inventory. When you cut back on slow-moving products, it can have the added benefit of reducing your inventory. Less money tied up in older inventory may free up cash to invest in other areas of your business.
- Increase your prices. Raising prices can potentially boost profits, but the process is tricky. Before you increase prices across the board, consider starting with a test on a few products or services.
- Lower costs. Your business might generate a ton of sales, but if your expenses are high, it can cut into your profit margins. There are numerous ways to cut costs. You can negotiate better prices with vendors or buy supplies elsewhere. You might consider relocating your headquarters or leasing out unused space in your warehouse to someone else. The possibilities are practically endless.
- Attract new customers. In general, it’s easier (and more cost-effective) to keep the customers you already have. But if you manage the process carefully, expanding your market might give your company a boost in the sales department. Plus, if you’ve recently increased your prices, it may be easier to get new customers to pay the higher costs.
Final Word: Profitability Ratios
Even if you’re not at a stage in your business where you’re looking for investors, tracking financial ratios can be useful. But ratios can mislead you if you don’t run these calculations regularly.
Imagine a pool company, for example. This particular retailer would likely get very different results if it ran profitability ratio calculators before and after the summer season.
Your best bet is to track profitability over time. It’s fine to start with a small set of reports, but run them at regular intervals (e.g., monthly, quarterly, etc.). Then, as your business grows, you can add additional reports, hopefully gaining more knowledge to improve your business in the future. You can even hire a professional to run these calculations for you and help you analyze the best way to react to the results you discover.
Finally, remember that your company’s profitability isn’t the only figure you should be tracking as a small business owner. It’s also wise to monitor your business credit scores. Nav makes it easy to keep an eye on your business credit reports and scores or find the right business credit cards for you. You can access both for free when you register for a Nav account.
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One response to “Profitability Ratios: What They Are, Types, How to Use, and Importance to Businesses”
I wanted to ask a question
Do you include sales on credit when calculating profitability ratios??
What do you do with sales on credit??