When it comes to running a business, the ultimate goal is to see it succeed. Profitability ratios allow you to measure your company’s financial performance within a specific period. These metrics are important because it gives business owners an insight into how their company is generating profits from its operation.
If you aren’t tracking your profitability metrics at present, this is probably the best time to start calculating them. This article will discuss the different types of profitability ratios you should be tracking in your business. But before that, let’s talk about its definition first.
Profitability Ratios Defined
Profitability ratios are a group of metrics that tell how efficiently the business is generating profit or earnings based on the company’s revenue, operating costs, investments, and shareholders’ equity within a specific timeframe. It tells you how your business is performing financially in that specific month or quarter.
Profitability ratios obtained from a single quarter won’t tell you much about how your company is doing. To assess your company’s profitability, you must keep track of the metrics regularly (i.e., monthly or quarterly). You then compare the ratios from the different quarters and assess whether your business is making progress towards growth.
Why Profitability Ratios Matter
Since it helps track your business’ financial performance, profitability ratios let owners and managers strategize and create a plan that will help steer the company in the direction of growth. Suppose, for some reason, your profitability ratios indicate that your company’s performance for a specific quarter isn’t as good as the previous quarter. In that case, the management can implement strategies to boost the company’s performance and increase its profitability by the next quarter.
On the other hand, if your ratios show that your company is doing better than the previous quarter, business owners can learn what strategies are working and continue identifying opportunities that would further bolster their company’s profitability, and therefore, growth.
Your profitability ratios are also great data to use when attracting investors. If they see that your startup is actually doing well throughout different quarters, more people would be enticed to buy a share or stock from your company. With that, you’ll have more funds to put towards pursuing business opportunities.
Types of Profitability Ratios
Businesses use different metrics to track their company’s profitability. Profitability ratios are usually classified into two categories: margin and return ratios.
Margin ratios tell how efficient the business is in turning its revenues into profits. It’s further divided into three categories – net profit margin, gross profit margin, and operating profit margin. Here’s how each of them works:
Net Profit Margin
Net profit margins reveal how much money is left from your sales revenue after paying down all of your financial obligations (i.e., taxes, operating expenses, and overhead costs). It shows businesses the percentage of the sales that actually make it to the company’s bottom line.
To calculate your net profit margin, you simply have to divide your revenue from your net income (or net sales) then multiply the result by 100 to get the percentage. The resulting number is then your net profit margin. Your formula should look like this:
Net Profit Margin (%) = (Net Income / Revenue) x 100%
Gross Profit Margin
Your company’s gross profit margin shows how much of the company’s revenue is left after deducting the costs the company incurred in producing its products, or what is known as the cost of goods sold (COGS).
You can calculate your gross profit margin by dividing your gross profit by your revenue and multiplying the result by 100.
Gross Profit Margin (%) = (Gross Profit / Revenue) x 100%
Higher profit margins indicate that the business is efficient in carrying out its business operations, leading to a positive gross profit – high enough to cover the manufacturing and other operating expenses. It could also result in higher profits for the company owners and shareholders.
Operating Profit Margin
The company’s operating profit margin looks at what’s left of the business’ revenue after deducting the COGS and operating expenses (employee wages, raw materials, etc.) but before the tax is taken into account.
You can calculate your business’ operating profit margins by using this formula:
Operating Profit Margin (%) = (Operating profit / Revenue) x 100%
A low operating margin (less than 50%) could indicate that you’re spending too much on your operating costs. With that, you might want to revisit your budget and identify areas on which you can cut costs without sacrificing your products' quality.
Return ratios show how efficient the company is in generating profits relative to its assets and equity. Any stocks, equity, or debt in the company is taken into consideration in this profitability metric.
Return ratios are classified into return on assets (ROA) and return on equity (ROE).
Return on Assets (ROA)
Return on assets represents how efficient the company is in generating profits in relation to the total asset it holds. ROA shows business owners the percentage of earnings for every dollar of asset it holds.
The formula for ROA goes as follows:
Return on Assets (%) = (Net profit / Total assets) x 100%
The higher the resulting number is, the more efficient the company is in utilizing its assets to generate profits.
Return on Equity (ROE)
Return on equity shows the earnings the company incurs for every dollar of equity it holds. Investors are usually more interested in calculating the company’s ROE since it measures how much return the company generated through their investments.
To measure the ROE, use the formula below:
Return on Equity (%) = Net income / Average shareholder’s equity) x 100%
ROE is also a measure of how well the company’s managers utilize the resources provided by the shareholders. It could also be used to track how the owners and managers are handling the company.
Generally, the higher the ROE is, the more efficient the company is in utilizing the investments and equity to generate a return. On the other hand, lower ROEs could indicate inefficient management of equity.
Profitability Ratios: Final Thoughts
Tracking your profitability ratios will help you determine where your business currently stands financially. Even if you’re not currently looking for an investor for the company, keeping tabs on your financial performance will help you identify which areas in your business need improvement so you can take the appropriate action. The better your profitability ratios are, the more your company will grow. This will also translate to better chances of attracting investors in the future.