How to Use Profitability Ratios to Improve Financial Performance

June 10, 2024
two small business owners figuring out profitability ratios

So you’ve just launched your business, and sales are picking up. Seeing money coming in is exciting. But you’re not sure how your company is doing financially. 

That’s where profitability ratios come in. In this article, you’ll learn how these metrics reveal the true picture of your financial health. We’ll also show you how these profitability measurements can enhance your company’s performance.

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What Are Profitability Ratios?

Profitability ratios help you see how good your company is at making money when you’re overwhelmed with financial records and statements. These ratios compare the amount your business earns to what it spends. This gives insight into how well your company operates and generates profits.

What Do Profitability Ratios Measure?

These ratios reveal how successfully a business is generating profit related to its:

  • Revenue
  • Expenses (including cost management and operating profit margins)
  • Total assets
  • Investment returns
  • Growth potential

Why are Profitability Ratios Important? 

Profitability ratios assess your business’s financial health. Without them, you’re stuck guessing how your business is performing. But these ratios show the profitability of your cash flow, giving you a better idea of whether your business is earning or losing funds. 

Knowing your profitability ratios:

  • Identifies strengths and weaknesses in operations
  • Guides better decision-making and strategic planning
  • Evaluate your company’s performance and potential for growth
  • Compares financial performance against competitors 
  • Attracts investors by showcasing your company’s financial health and profitability

Types of Profitability Ratios Explained

profitability ratios type

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

Margin Ratios

These ratios:

  • Measure the percentage of revenue that becomes profit at different expense stages
  • Indicate how well a company manages costs and converts sales into profit

Examples of Margin Ratios

  • Gross Profit Margin shows the percentage of revenue left after deducting the cost of goods sold (COGS).
  • Operating Profit Margin shows the percentage of revenue left after covering operating costs like wages and rent.
  • Net Profit Margin indicates how much money remains from revenue after paying all expenses, including taxes.
  • Pretax Margin provides profitability ratios after deducting all expenses except taxes.
  • EBIT Margin (Earnings Before Interest and Taxes) highlights a company’s operating profitability before deducting interest and taxes.
  • EBITDA Margin (Earnings Before Interest, Taxes, Depreciation, and Amortization) shows a company’s operating income before deducting expenses.

Return Ratios

  • Measure the profit generated from investments in assets or equity
  • Show how effectively a company uses its resources and investments to generate profit
  • Provide insights into a company’s ability to turn sales into profit from different perspectives

Examples of Return Ratios

Some of the most common types of profitability ratios are:

  • Return on Assets (ROA) shows how effectively a company uses its assets to generate profit. Higher ROA means better use of assets.
  • Return on Equity (ROE) measures the return generated on shareholders’ equity. It shows how well a company uses investments to generate growth.

Calculating Profitability Ratios

Profitability ratios consider all your business expenses to measure how well you turn revenue into profit. Some of the different costs you might include in your calculations include:

  • Operating Expenses (OpEx). These expenses include the everyday fixed costs needed to run the business, like salaries and office supplies.
  • Non-Operating Expenses. These include costs not part of core business activities, like loan interest.
  • Cost of Goods Sold (COGS). Direct costs are tied to producing goods or services like raw materials and shipping costs.
  • Variable Expenses. These are costs that change based on the level of production or sales, such as utilities and labor. 

Profitability Ratio Formula

Profitability ratios compare a measure of profit (called a profit metric) to your company’s total revenue. This formula applies to all types of ratios—including margin and return. 

Here’s the profit ratio calculation:

Formula: Profitability Ratio (%) = Profit Metric ÷ Revenue × 100

For example:

  • If a company has a profit metric (e.g., net profit) of $15,000 and revenue of $100,000: Profitability ratio = $15,000 ÷ $100,000
  • This equals 0.15
  • Multiply 0.15 by 100 to get 15

This means that 15% of your total revenue is profit.

Example Profitability Ratio Calculations 

small business owner calculating profitability ratios

Here are examples of some common ratios you might need to calculate.

Gross Margin Ratio

This margin shows a percentage of revenue that exceeds the cost of goods sold (COGS). To calculate the gross margin ratio: 

Formula: Gross Margin Ratio (%) = Gross Profit ÷ Revenue × 100

For example:

  • If a company has revenue of $100,000 and COGS of $60,000, the gross profit is $40,000.
  • To find the gross margin ratio, divide $40,000 by $100,000, which gives you 0.4.
  • Multiply 0.4 by 100 to get 40%.

This means 40% of the revenue remains after covering the cost of goods sold and is available to cover other expenses.

FROM ONE OF OUR PARTNERS — How to Calculate Gross Profit Margin

EBIT Margin Ratio

EBIT margin highlights a company’s operating profitability without the influence of tax and interest expenses. To calculate the EBIT margin ratio: 

Formula: EBIT Margin Ratio (%) = EBIT ÷ Revenue × 100

For example:

  • If a company has revenue of $100,000 and EBIT of $20,000, divide $20,000 by $100,000 to get 0.2. 
  • Multiply 0.2 by 100 to get 20%.

If the EBIT Margin Ratio is 20%, it means the company keeps 20 cents as operating profit for every dollar of revenue. That number is before accounting for interest and taxes.

EBITDA Margin Ratio

The EBITDA ratio shows a company’s earnings before deducting costs for non-operating expenses. To calculate the EBITDA margin ratio: 

Formula: EBITDA Margin Ratio (%) = EBITDA ÷ Revenue × 100

For example: 

  • If a company has revenue of $100,000 and EBITDA of $25,000, divide $25,000 by $100,000 to get 0.25. 
  • Multiply 0.25 by 100 to get 25%.

This means the company retains 25% (or 25 cents of every dollar) of EBITDA revenue.

Net Profit Margin Ratio

This ratio shows how much money is left from revenue after all expenses, including taxes, are paid. To calculate net profit margin: 

Formula: Net Profit Margin Ratio (%) = Net Income ÷ Revenue × 100

For example:

  • If a company has a revenue of $100,000 and a net income of $10,000, divide $10,000 by $100,000 to get 0.1. 
  • Multiply 0.1 by 100 to get 10%.

This means the company earns a net profit of 10% (10 cents for every dollar) of revenue after paying all expenses. 

Analyzing Profitability Ratios

Analyzing financial ratios helps companies see how well they turn revenue into true profit. This ratio analysis shows how healthy and efficient a company is with its money, assisting leaders to make better decisions. To analyze these ratios, companies must:

  • Collect Financial Data. Gather information from income statements, balance sheets, and other financial statements.
  • Calculate Key Ratios. Focus on essential ratios like gross margin, operating margin, and net profit margin.
  • Compare Over Time. Look at these ratios over different periods to spot trends and changes.
  • Benchmark Against Others. Compare your ratios with those of other companies in the same industry to find strengths and weaknesses.
  • Adjust for Non-Recurring Items. Remove one-time expenses or income to get a clearer picture of regular performance. Not doing so risks distorting your ratios and potentially misrepresenting your company’s true operational efficiency. Only tracking recurring expenses gives a more accurate picture.
  • Assess Asset Efficiency. See how well your total assets generate revenue and profit.
  • Control Costs. Check how effectively the company manages its expenses compared to its revenue.
  • Identify Profitable Products/Services. Determine which products or services are most profitable and monitor changes over time.

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5 Benefits of Profitability Ratios

Think of profitability ratios as a flashlight in a dark room. Using them lets you illuminate the state of your company’s finances. They provide business owners and stakeholders with many benefits:

  1. Reveal Financial Stability. Profitability ratios help creditors assess a company’s ability to meet its financial obligations.
  2. Identify Areas Needing Improvement. These margins highlight specific areas in your company that may require improvement.
  3. Assess ROI. Knowing your return on assets helps investors evaluate the potential return on their investments.
  4. Show Long-Term Viability. These ratios illustrate your company’s ability to sustain operations and grow over time.
  5. Support Decision-Making. Understanding your financial performance helps you make informed decisions to enhance profitability. 

Take Control of Your Business Finances With Invoice Simple 

Understanding profitability ratios can help you identify strengths and weaknesses in your business. To put these insights into action, you need the right tools. Invoice Simple’s invoice management software makes it easy for business owners to track monthly expenses, share financial reports, and manage all your finances in one place. 
Ready to take control of your financial performance the simple way? Start using Invoice Simple today to streamline your financing for better business success.

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