How to calculate profitability ratios for your business

How well is your business turning its sales into actual profit? Learning how to calculate profitability ratios gives you a clearer picture of your business’s performance, considering your revenue, assets, equity and all other incoming finances. There are several types of profitability ratios that can come in handy in different situations. Keep reading to learn about different profitability ratios, how to calculate them and what they can tell you about your company’s financial strengths and weaknesses. 

What you’ll learn:

• Profitability ratios are financial metrics that, when looked at together, can provide insight into a business’s financial health by showing how well it generates profit relative to its revenue, assets and equity. 

• There are different types of profitability ratios, and they typically fall under two categories: margin ratios and return ratios.

• Margin ratios show how well a company turns revenue into profit. These ratios include operating profit margin, gross profit margin and net profit margin.

• Return ratios, which include return on assets (ROA) and return on equity (ROE), reflect a company’s ability to generate returns from its investments.

• You can use profitability ratios internally to make business decisions and track performance. Externally, investors often look at a business’s profitability ratios when making investment decisions.

Profitability ratios are different financial metrics you can use to evaluate how well a business generates profit when compared to its assets, revenue and equity over a specific period of time. When looked at together, the various types of profitability ratios can provide a snapshot of a business’s financial health. In general, a company with higher profitability ratios is making money more efficiently than a company with lower profitability ratios. 

The different types of profitability ratios that companies may use, depending on the insights they’re trying to gain, can generally be grouped into one of two categories: margin ratios and return ratios. 

• Margin ratios: These are metrics that show how well a company can turn revenue into profit at different stages of its operations. Some common profit margin ratios include operating margin, gross margin, net profit margin, cash flow margin and earnings before interest, taxes, depreciation and amortization (EBITDA) margin. 

• Return ratios: These metrics provide insight into how effectively a company generates returns on investments that its shareholders make. Examples of return ratios include return on equity, or ROE, and return on assets, or ROA.

Here are some of the main profitability ratios and how to calculate them:

Operating margin—also referred to as return on sales—measures a business’s profitability from its core operations. This metric can be useful when comparing your business to companies with different financial structures or tax situations. Operating profit margin ratio can be calculated by dividing a company’s operating income by its total revenue. Operating income—also known as earnings before interest and taxes (EBIT)—can be determined by subtracting cost of goods sold (COGS) and operating expenses, like wages and depreciation, from revenue. 

Once calculated, the operating margin shows how much profit remains after accounting for operating expenses.

Operating profit margin ratio formula: Operating profit margin = Operating income / Revenue

Gross margin shows how much profit a business keeps from its revenue after accounting for the direct costs of producing goods or services, such as direct labor or materials. To calculate the gross profit margin ratio, subtract COGS from revenue, then divide by revenue. Compared to operating margin, gross margin only includes direct production costs, while operating margin takes into account all of the expenses required to run a business.

Gross margin can be a good indicator of how production costs factor into your business’s overall financial health.

Gross profit margin ratio formula: Gross profit margin = (Revenue − COGS) / Revenue

Net profit margin is often considered the “bottom line” ratio because it shows how profitable a company is after accounting for all expenses, including taxes and interest. A net profit margin ratio can be calculated by dividing net profit by total revenue. This ratio provides a glimpse into a business’s profitability. But because the net profit margin includes one-time expenses and income—like the purchase or sale of an asset—it does have some limitations.

This is why other profitability ratios—like gross margin and operating margin—are also considered when looking at the overall financial performance and health of a business.

Net profit margin ratio formula: Net profit margin = Net profit / Revenue

A cash flow margin shows how well a business can turn revenue into cash. This profitability margin highlights the relationship between cash flows from operating activities—like the sale of goods or services—and net revenue.

A positive cash flow means a company has more funds coming in from sales to cover business activities, like paying suppliers, paying dividends or buying assets. On the other hand, if a business has negative cash flow, you might need additional funds from loans or investors to keep the company afloat. 

Operating cash flow profit margin ratio formula: Operating cash flow profit margin = Cash flow from operations / Net revenue

EBITDA refers to a company’s profitability before considering nonoperating costs (like interest and taxes) and noncash expenses (like depreciation and amortization). EBITDA margins provide a more stable view of profitability because they exclude expenses that can fluctuate. 

A business’s EBITDA can be a good indicator of operational efficiency and how much the company earns from its core operations. But since the EBITDA margin excludes items like interest on debt and noncash expenses, it’s important to consider other profitability margins to get a clearer picture of a business’s financial health.

EBITDA profit margin ratio formula: EBITDA profit margin = EBITDA / Revenue

ROA is a return ratio that measures how efficiently a company uses its existing assets to turn a profit. You determine ROA by comparing net income to the total assets the business holds. ROA shows how much after-tax profit a company generates for every dollar of assets it holds.

A high ROA can signal that a business is productive and uses its resources efficiently. 

ROA ratio formula: ROA = Net income / Average assets

ROE is a financial metric that shows how well a company generates profit from shareholder equity. ROE can be calculated by dividing net income by average shareholders’ equity. Shareholder equity can be determined by subtracting a company’s liabilities from its assets. 

This metric can show a business’s return on net assets and how effectively it generates profit. A high ROE could mean a company is successfully turning equity financing into profit. Investors often look at a company’s ROE when deciding whether the company is a good investment.

ROE ratio formula: ROE = Net income / Average shareholders’ equity

As a business owner, it’s important to know your company’s profitability ratios because they can reflect the success of your business operations. The information gained from these metrics can help you evaluate your company’s bottom line and determine the business’s valuation. And once you know your company’s various profitability ratios, you can make informed business decisions on matters such as:

• Setting a pricing strategy

• Allocating resources more effectively

• Identifying ways to scale your company, like offering new products

• Reviewing which suppliers or customers are best to work with

• Setting short- and long-term business goals

• Deciding which initiatives to focus on first

• Finding opportunities to increase your company’s valuation

You can also use your business’s profitability ratios as a benchmark to compare your performance to other companies that are similar in size and industry. And tracking these ratios year over year can help you look at your operations from a broader perspective to see whether performance is improving over time.

Investors may also request your business’s profitability ratios to determine if your company would be a good investment to add to their portfolio. Specifically, investors look at these margins to see if the business is profitable enough to generate a healthy return on their investment.

When analyzing your business and its finances, calculating profitability ratios can provide an overall picture of how well your business is performing. If your business’s profitability ratios tell a positive story, you might consider ways to drive growth that will take your company to the next level. If the profitability ratios are negative, you could look for ways to take corrective action and improve operations. 

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