Profitability ratios: what they are and how to use them

Profitability ratios are financial metrics that business owners, investors, and analysts use to assess company earnings. Profitability ratios measure profit and can help you determine:

• How well your business minimized costs while generating profits.
• If you are maximizing the use of company assets as you generate profits.
• The level of return you are generating for company shareholders.

Overall, you can use profitability ratios to monitor business performance. Read on to learn more about ratios that measure rates of return and use gross profits, operating profits, and net income.

How to use an income statement to compute ratios

A profitability ratio analysis uses information from your income statement. For example, Premium Cabinets is a manufacturing company. Their 2019 income statement follows:

Premium Cabinets uses a multistep income statement, which they generate by subtracting sales from the cost of goods, operating expenses, and non-operating expenses. The formula follows:

Sales – cost of goods – operating expenses – non-operating expenses

Every set of company financial statements should include a multistep income statement. Each part of the statement provides details that can help you make informed business decisions. And data from a multistep income statement can help you generate financial ratios.

• Revenue includes sales and other transactions that generate cash inflows, like the gain on the sale of an asset.
• Cost of goods sold includes material and labor costs that are related to the product or services sold.
• Operating expenses include costs that are not related to the product, like insurance expenses and rent or mortgage costs.
• Non-operating expenses are interest payments and income tax expenses.

What are profitability ratios?

Profitability ratios help business owners evaluate company earnings. Profitability ratios are useful because you can compare performance to prior periods, competitors, or industry averages. But keep in mind that some industries have seasonal fluctuations in profitability. For example, many retailers generate the majority of company sales in the fourth quarter of each year.

To assess profitability over the last three years, you should focus on fourth-quarter profits. A well-managed retailer can increase fourth-quarter sales from one year to the next. Comparing the first quarter of 2017 to the fourth quarter of 2018 would not be useful. Generally, if you can increase ratios, your business will be more profitable.

What do profitability ratios measure?

Profitability ratios measure company earnings using margin ratios and return ratios.

Margin ratios focus on the profit generated for each dollar of sales. If you can generate more profit per sales dollar, your business can be more profitable. You can also generate more profit on a smaller dollar amount of sales. Meanwhile, return ratios measure how well your company is generating a return for shareholders.

The most common profitability ratios use balances taken from the multistep income statement. Most margin ratios use revenue in the denominator, and most return ratios use net income in the numerator.

How to review profitability ratio formulas

Most commonly, profitability ratios measure gross profit margins, operating profit margins, and net profit margins. To understand why these ratios are useful, consider a plumbing business.

If a plumber generates $300,000 in sales a year, their goal is to maximize earnings (profit) generated from sales. Margin ratios explain how well the plumber generates profits from each dollar of sales.

The plumber owns a $20,000 truck and $5,000 in equipment. How much profit could the plumber generate by using the $25,000 in assets? If the plumber invested $40,000 to start the business, how much profit could they earn on his investment? We can answer these questions using return ratios.

How to use the gross profit margin formula

Gross profit is total sales subtracted from the cost of goods sold. The cost of goods sold balance includes all costs that are related directly to the creation and sale of a product or service. Gross profit is stated as a dollar amount. The gross profit margin is expressed as a percentage. The gross profit formula follows:

(Total revenue – the cost of goods sold) / total revenue

Note that the gross profit margin uses revenue instead of sales. Premium’s revenue includes $1,000,000 in sales and a $2,000 gain on sale. Using the formula, we find Premium’s gross profit margin is 40.1%. The formula follows:

($1,002,000 – $600,000) / $1,002,000 = 40.1%

The gross profit margin is an important metric because, often, the cost of goods sold is a company’s largest expense. Premium earns slightly over 40 cents for each dollar of revenue. This ratio tells the business owner how well they’re minimizing the cost of goods sold. The business’s operating profit margin (or operating margin) includes more expenses.

How to use the operating profit margin formula

The operating profit margin formula divides operating profit and total revenue. It explains a company’s ability to generate a profit from normal business activities. The formula follows:

Operating profit / total revenue

Non-operating activities are not generated from normal business operations. Premium manufactures cabinets, so selling a piece of equipment is not Premium’s main business. Paying interest on a loan is also a non-operating activity. Using the operating profit margin formula, Premium finds its margin is 19.9%. The formula follows:

$200,000 / $1,002,000 = 19.9%

The operating profit margin is lower than the 40.1% gross profit margin. As the income statement indicates, operating profit includes $200,000 in expenses that are not included in gross profit. Meanwhile, the net profit margin generates a lower profit percentage than the operating profit margin.

How to use the net profit margin formula

The net profit margin formula divides net income by total revenue. Net income includes all income and expenses, including taxes. The formula follows:

Net income / total revenue

Premium’s net income includes interest expenses and tax expenses. Using the net profit margin formula, Premium finds its margin is 13.8%. The formula follows:

$138,000 / $1,002,000 = 13.7%

Generating cash inflows is just as important as earning a profit. Many profitable companies struggle to collect enough cash to operate the business each month. 

How to use the free cash flow margin formula for cash management

The free cash flow margin divides free cash flow by sales. This margin formula uses net sales in the denominator, rather than revenue. The formula follows:

Free cash flow / sales

When you think of free cash flow, consider the cash inflows you don’t have to use for a particular purpose. You have the flexibility to use the cash for any purpose, which is why free cash flow is so valuable.

Unlevered free cash flow, or free cash flow to the business, represents cash inflows after subtracting

• Depreciation expenses
• Taxes
• Working capital
• Capital investments

Depreciation expenses and taxes are listed in the income statement. Working capital and capital investments, however, are not income statement accounts. The capital investment balance is the dollars you’d need to maintain and replace assets over time.

How to understand working capital

Working capital is current assets minus current liabilities. The formula measures a business’s ability to generate sufficient cash inflows to operate in the short term (six to 12 months).

Current assets include cash and assets that will convert into cash within a year. You expect accounts receivable and inventory balances, for example, to collect in cash over a period of months.

Similarly, current liabilities include balances you must pay within a year, including accounts payable and the current portion of long-term debt. If a business converted all current assets into cash and used the cash to pay all current liabilities, any cash remaining is working capital.

Financially healthy businesses have a positive working capital balance. Their current assets are greater than their current liabilities. Free cash flow assumes that you’ll set aside working capital for business operations, which is why you subtract the balance from the cash flow total.

How to calculate the EBITDA margin formula

EBITDA is the most common measure to assess earnings. It’s the earnings before interest, taxes, depreciation, and amortization. The EBITDA margin formula divides EBITDA by revenue. The formula follows:

EBITDA / revenue

Businesses use assets to produce revenue. Depreciation expenses post as tangible (physical) assets as you use them. Premium, for example, owns a $10,000 machine with a useful life of 15 years. The machine’s cost is reclassified to a depreciation expense as Premium uses the machine to produce revenue.

Similarly, amortization expenses post when you use an intangible asset in the business. Let’s assume that Premium buys a patent on a manufacturing process, and the patent has a remaining life of 20 years. Premium will reclassify the cost of the patent to an amortization expense over 20 years.

The EBITDA formula adds back interest, tax, depreciation, and amortization expenses. Using the EBITDA margin formula, Premium’s margin is 22.1%. The formula follows:

($138,000 + $18,000 + $46,000 + $20,000) / $1,002,000 = 22.1%

The plumbing example above illustrated the importance of earning a return on the assets you purchase and company equity. The last three ratios measure rates of return.

How to calculate your return on assets

Return on assets (ROA) measures how effectively a company uses assets to generate revenue and profits. The formula divides net income by average total assets. An average balance is the sum of the beginning period balance and the ending period balance, divided by two. The ROA formula follows:

Net income / average total assets 

Every business uses assets to generate revenue, so business owners must maintain and replace assets. Let’s assume that two restaurants each spend $300,000 on assets to operate the business. Restaurant A generates $800,000 in annual sales. Restaurant B produces $500,000. So restaurant A is earning a higher return on the same $300,000 investment in assets.

How to calculate the return on equity

Return on equity focuses on the dollars that shareholders invest in, rather than assets purchased. Return on equity measures how effectively a company uses shareholder equity to generate profits. The return on equity formula divides net income by the average shareholder’s equity. The formula follows:

Net income / the average shareholder’s equity

Let’s say that two restaurants have each raised $1 million by issuing stock to investors. Restaurant A generates $800,000 in annual sales. Restaurant B produces $500,000. So restaurant A is earning a higher return on the $1 million in equity.

Capital is money invested in the company to purchase assets and operate the business. A well-managed business works to increase its return on company capital.

How to calculate your return on invested capital

Companies raise money by selling equity (issuing common stock) or taking on debt. Stock and debt are both considered capital. The return on invested capital calculates the rate of return earned by bondholders and shareholders. The formula multiplies earnings before interest and taxes by one minus your tax rate. The formula then divides that number by the sum value of debt and equity. The formula follows:

EBIT x (1 – tax rate) / (value of debt + value of equity)

Interest expense on debt is tax-deductible, which is why you multiply EBIT by one minus your tax rate. This is the most complicated ratio formula, so you may need to use accounting software for the calculation.

What is a good profitability ratio?

Your business’s ideal profitability ratio depends on company trends, your competitors, and industry benchmarks.

• Company trends: If your ratios are trending up year over year, your business is more profitable. A 10% increase in the gross profit margin means that sales are increasing, and you’re controlling the cost of goods sold balance.
• Competitors: Your business and your competitors operate in similar environments. Your material and labor costs and prices are similar. If you can generate better profitability ratios, you can beat the competition.
• Industry benchmarks: Industry benchmarks help you understand the level of profitability you should expect. If net profit margins average 12% in your industry, a 15% margin is a solid performance.

It takes effort, but you should review your profitability ratios each month and make changes to improve outcomes.

4 ways to improve your profitability ratios

1. Embrace technology to work more efficiently

Accounting software can help business owners post accounting transactions and create invoices quickly, which reduces costs.

2. Increase revenue

Businesses can increase revenue by raising prices. But price increases can be difficult in saturated industries. The most effective way to increase revenue is to increase sales among your existing customer base. You can also use promotions, rewards, and testimonials to promote your products and increase sales.

3. Reduce material costs

You can reduce material costs by negotiating lower prices with your suppliers. If you’re a large customer who buys materials every month, you may negotiate a lower price. Cost and use drive your material costs, so analyze your production and avoid wasting materials.

4. Decrease labor costs

Labor costs are a function of the hourly rate paid and the number of hours worked. And it’s tied closely to current economic conditions and the unemployment rate. If the economy is growing, you may need to pay a higher hourly rate to attract qualified workers. Otherwise, invest in training so that employees can work efficiently.

Use the best data to make key business decisions

Successful business owners use financial dashboards to monitor data and use the best information to make decisions. Tools like QuickBooks Online can help you create your financial dashboard and uncover financial insights.