Profitability Ratios Explained: 8 Foundational Profitability Ratios

Profitability ratios help you assess your business’s health by quickly quantifying how well you use money to make money. It offers investors a quick way to gauge the potential value of their investment, and it helps lenders assess your company’s ability to repay loans. Here’s what you need to know about common profitability ratios and how it’s relevant for your business and its stakeholders.

What are profitability ratios?

Profitability ratios are measures of a business’s ability to generate profit or income relative to revenue, costs, assets, and equity. Lenders and investors use profitability ratios to evaluate the business’s efficiency in using their capital to generate that profit.

Profitability ratios come in two types: margin ratios and return ratios. Margin ratios compare profit to total sales or revenue, using figures from a business’s income statement. Return ratios compare profit to the money invested in the business in the form of debt and equity capital, which are found on the business’s balance sheet.

Higher profitability ratios generally indicate success in generating profit and deploying capital toward profitable uses. You can use profitability ratios to compare your business’s current and past performance, as well as against similar businesses. You may also compare your profitability ratios against a benchmark, such as an index for your industry or a broader stock market index.

Types of margin ratios

• Gross margin
• Operating margin
• Pretax margin
• Net margin
• Cash flow margin

Margin ratios signify the margin, or degree, of a business’s profitability. Each subsequent profitability ratio shows a progressively lower level of profit as more categories of expenses are deducted from revenue.

Here are some key margin ratios:

Gross margin 

Gross margin, or gross profit margin, is the ratio of a business’s gross profit to its net sales or revenue. Gross profit is revenue minus the direct costs related to making products or services, known as cost of goods sold (COGS). The formula for gross profit margin, expressed as a percentage, is:

(Revenue - COGS) / Revenue x 100 = Gross Margin

Gross margin shows the basic profitability of a business’s production process before any other costs are taken into account.

For example, let’s say an online shoe company has $1 million in revenue in a quarter, and $400,000 in cost of goods sold, such as wholesale purchases of shoes for inventory. Its gross margin is:

(1,000,000 - $400,000)/$1,000,000 x 100 = 60%

Operating margin

Operating margin, or operating profit margin, is the percentage of revenue left after subtracting COGS as well as operating expenses, commonly referred to as selling, general, and administrative (SG&A) expenses or overhead. Since interest on debt and taxes aren’t yet counted, operating profit is sometimes called earnings before interest and taxes (EBIT). The operating profit margin formula is:

(Revenue - COGS - SG&A) / Revenue x 100

Using the hypothetical shoe retailer from above, let’s say it has $300,000 in operating costs (SG&A) in a quarter. Its operating profit margin then is:

($1,000,000 - $400,000 - $300,000) / $1,000,000 x 100 = 30% 

Pretax margin

The pretax margin measures profitability after all costs except taxes are deducted. It is determined by the following formula:

(Revenue - COGS - SG&A - Interest) / Revenue x 100

Pretax costs include interest payments, which (assuming IRS criteria are met) are tax-deductible for a business. Interest costs further reduce profit margin.

Say that the shoe retailer has $50,000 of interest payable on loans. Its pretax margin is

($1,000,000 - $400,000 - $300,000 - $50,000) / $1,000,000 x 100 = 25%

Net margin

Net margin, or net profit margin, most accurately reflects a company’s profitability—or its net income after deducting all costs. It's calculated by dividing net income by total revenue:

(Revenue - COGS - SG&A - Interest - Taxes) / Revenue x 100

or

Net Income/Revenue

Sticking with the example of the shoe retailer, its taxable income for the quarter is $250,000. Assuming a tax rate of 20%, its taxes are $50,000. Calculating the net profit margin looks like this:

($1,000,000 - $400,000 - $300,000 - $50,000 - $50,000) / $1,000,000 x 100 = 20%

Net profit margin is the most commonly cited of the profitability ratios, representing a company’s financial health and ability to generate income. The net profit margin ratio can indicate how much profit a company’s management is producing from sales while keeping costs under control.

This metric does have drawbacks: It can include extraordinary accounting items such as one-time gains or losses, which can skew comparisons of a business’s current and historical profitability, as well as comparisons to competitors that may not have such extraordinary items distorting their profit.

Cash flow margin

The cash flow margin measures a business’s operating cash flow, which appears in its cash flow statements, against revenue:

Cash Flow From Operations / Revenue x 100

Calculate operating cash flow by starting with net income, then adding back any non-cash expenses from the income statement, such as depreciation and amortization:

(Net Income + Depreciation + Amortization) / Revenue x 100

Let’s say the shoe retailer recorded $80,000 of depreciation in the value of its assets in the quarter, so it adds that amount back to net income to arrive at cash flow from operations. The cash flow margin then is:

($200,000 + $80,000) / $1,000,000 x 100 = 28%

Cash flow margin indicates how well a business turns revenue into cash. This is typically important for businesses that sell on credit and need to collect payments from customers. A greater cash flow margin indicates more cash available for a business to pay its employees, vendors, and lenders, or to purchase more assets. Diminishing or negative cash flow may mean the business is generating profit but is losing money as customer payments lag.

Types of return ratios

• Return on assets
• Return on equity
• Return on invested capital

Return ratios quantify how well a business uses capital, both debt and equity. They include:

Return on assets

The return on assets (ROA) ratio compares a company’s profit, or net income, found on the income statement, to total assets, which is found on the balance sheet:

Net Income / Total Assets x 100

Let’s say the shoe retailer has total assets of $1.5 million, financed with $1 million of loans and $500,000 of owners’ (shareholders’) equity. Its net income for the quarter is $200,000. So return on assets is:

$200,000 / $1,500,000 x 100 = 13.3%

Ideally, the more assets a company has, the greater its potential revenue and profit. Since economies of scale help lower costs and improve profit margins, returns may grow at a faster rate than assets, ultimately increasing ROA.

Return on equity

A business’s return on equity (ROE) ratio measures how efficiently it uses shareholders’ equity to generate profit. The calculation divides net income by equity:

Net Income / Shareholders Equity x 100

With a smaller denominator than return on assets, a business’s return on equity is often substantially higher. For example, if the shoe retailer’s equity is $500,000, its return on equity is:

$200,000 / $500,000 x 100 = 40%

The higher rate compared with return on assets illustrates the use of leverage, or debt financing, to enhance ROE. Since two-thirds of the shoe retailer’s assets ($1 million) are debt-financed, its net income increases by using debt. So the numerator in the ROE calculation is boosted by debt-financed profit, while the denominator is smaller because it excludes debt. 

Return on invested capital

The return on invested capital (ROIC) ratio reflects how well a business uses capital from both debt and equity to generate profit, rewarding equity investors and repaying lenders. It’s calculated by subtracting dividend payments from net income and then dividing that number by total capital:

(Net Income - Dividends) / (Debt + Equity) x 100

If the shoe retailer paid no dividends, then its return on invested capital would be the same as its return on assets:

$200,000 / $1,500,000 x 100 = 13.3%

Any dividend payments would lower the return on invested capital. For example, let’s say the shoe retailer paid a $50,000 dividend in the quarter. The ROIC then is:

($200,000 - $50,000) / $1,500,000 x 100 = 10%

How to analyze your profitability

1. Collect financial data
2. Calculate breakeven point
3. Examine historical profitability ratios
4. Know your competitors

To get a reading of your business’s profitability and analyze various profitability ratios, you will need to do several things:

1. Collect financial data

The data you need for profitability ratios is mainly drawn from the three key financial statements—the income statement, balance sheet, and cash flow statement. These statements provide the relevant entries for calculating ratios, such as revenue, profit, assets, equity, and cash flow from operations.

2. Calculate breakeven point

You’re at the threshold of profitability when you reach your breakeven point. Determine your breakeven point with the following formula:

Breakeven Point = Total Fixed Costs / (Contribution Margin Per Unit / Sale Price Per Unit)

In this formula, fixed costs are those that stay the same even when your output increases, and contribution margin is product price minus variable costs per unit.

At this stage, you might perform some what-if analysis to test breakeven assumptions about product prices, overhead and operating costs, and financing.

3. Examine historical profitability ratios

Compare your profitability ratios against previous periods to identify patterns. If your business tends to have seasonal fluctuations throughout the year, compare like periods, such as this year’s second-quarter net margin to last year’s second-quarter net margin. Also, compare profitability ratios internally, such as gross margin versus operating margin, to analyze opportunities for reducing operating expenses and increasing profit.

4. Know your competitors

Compare your profitability ratios against competitors to gain a sense of your place within the market. This is known as peer group analysis. You may also gauge your performance against benchmarks, such as an average or index for your industry. If your growing small business has a net profit margin of 10%, for example, how does it compare with the average net margin of companies in a small-cap index?

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