What are Profitability Ratios?
Profitability ratios are financial metrics used to assess a business’s ability to generate earnings relative to its revenue, operating costs, and other metrics using data from a specific point in time or over the course of a time period.
In most cases, the higher a profitability ratio the better. It’s best to use ratios in comparison to a competitor or to the same ratio from a previous period of your own business to monitor growth. You can also compare your company’s ratio to average ratio’s for your industry as a whole.
Tip: If you’re a seasonal business, such as a retailer, do not compare ratios month over month. In the retail industry, your fourth-quarter ratios will almost certainly be higher than your first-quarter, so comparing your first-quarter 2020 to fourth-quarter 2019 would not allow for an appropriate comparison. However, comparing first-quarter 2020 to first-quarter 2019 would be beneficial.
What are the Most Important Profitability Ratios?
- Gross profit margin
- Operating profit margin
- Net profit margin
All of these come from your company’s income statement. Each ratio is ordered by the number of expenses taken out and they build off of one another.
As a refresher, these are the definitions of gross profit, operating profit, and net profit.
Gross profit = Net sales – the costs of goods sold
Net sales=gross sales minus any returns and discounts.
Operating profit = gross profit – selling and administrative expenses
Administrative expenses consist of everything from labor costs to payroll taxes to rent to depreciation. Operating profit includes all of your business expenses except for taxes.
Net profit = Operating profit – taxes
To get the three profitability ratios for each term, simply divide each by net sales and show the result as a percentage.
For example, if your business had gross sales of $500,000 last year, and net profits were $50,000, you would have a ratio of $50,000/$500,000 or 5%.
By using percentages, you’ll easily be able to compare your business versus your competitors, industry averages, and previous period percentages of your own business.
Gross Profit Margin Ratio
Gross profit margin is the percent of revenues that remain after deducting the cost of goods sold (COGS):
- Gross Profit Margin = (Gross profit/sales) x 100
Multiply by 100 to convert the ratio into a percentage.
Why is Gross Profit Margin Ratio Important?
Without a healthy gross profit margin, your company won’t be able to pay its operating expenses and other liabilities in the future.
You can also use gross profit margin to look at the effectiveness of individual products or services. The gross profit of one product divided by the total revenue generated by that product is one way to measure the efficacy of that product. You can use the ratio is determine whether you need to change pricing strategy to get a higher profit or change supply chains to reduce direct costs.
Your gross margins shouldn’t fluctuate drastically from one period to the other (unless you’re a seasonal business, in which case it shouldn’t). The only thing that would cause a severe fluctuation would be if the industry that you’re a part of experiences a widespread change that directly impacts your pricing policies or cost of goods sold.
Operating Profit Margin Ratio
This profit accounts for operating costs, administrative costs and sales expenses. It includes amortization rates and asset depreciation, but it does not include taxes, debt and other nonoperational or executive level costs. It tells you how much of each dollar is left after all the operating costs to run the business are considered:
- Operating profit margin = (Operating income/sales) x 100
Why is Operating Profit Margin Ratio Important?
The operating margin gives you a good look at how efficient your business is.
If you’re looking to compare your returns to others in the industry, this is the best ratio to do so, as it shows how well your business turn sales into pre-tax profits. It is a strong indicator of management skill and overall operational efficiency.
Many find this to be a much more objective evaluation tool than the net profit margin ratio.
Net Profit Margin Ratio
This is the most difficult type of profit margin to track, but it gives you the most insight into your true bottom line. It takes into account all expenses, as well as income from sources such as investments to get to your company’s profits:
- Net profit margin = (Net profit/sales) x 100
Why is Net Profit Margin Ratio Important?
Net profit margin, sometimes referred to as just “profit margin,” is the big-picture of your profitability. Net profit margin is similar to operating profit margin, except it accounts for earnings after taxes. It demonstrates how much profit you can truly extract from your total sales.
Yournet income also can be defined as your gross revenue minus pretty much all of your costs, including COGS, operating expenses, interest, taxes and other expenses.
Some industries like financial services, pharmaceuticals, medical, and real estate have high profit margins, while others are more conservative. Use industry standards as a benchmark, and perform an internal year to year comparison to assess your performance.
The Bottom Line
Investors and analysts typically use gross profit margin, operating profit margin and net profit margin to gauge the viability of a business and how efficient a company’s management is in earning profits relative to the costs involved in producing their goods and services. It’s best to compare the margins to companies within the same industry and over multiple periods to get a sense of any trends.
Common Size Ratios to Assess Your Business
Now that you know how to calculate the 3 most important profitability ratios, you can start analyzing each line item on your income statement and how it relates to sales to determine specific areas your business can improve upon.
Cost of Goods Sold
The cost of goods sold (COGS) is the sum of all the costs of selling your products or services.
Both variable and fixed costs can be included in the COGS calculation. As the name implies, the variable cost can and will change as a result of increases or decreases in production. These items include the cost of raw material.
Conversely, whether your machine runs full-tilt or sits idle, fixed cost will remain static. An example of a fixed cost is the mortgage or rent of a manufacturing plant.
Take the costs of goods sold and dived it by total sales, then multiply by 100 to get your percentage. Now, compare it to last year. Did your cost of goods sold ratio go down relative to last year? Did it increase? If so, why? How can you improve upon it?
Return on Investment
Return on investment is considered by many executives to be the most important profitability ratio. It measures the return on the owner’s investment (or owners’, if there are more than one.) For you as a small business owner, the return on investment figure can help you decide whether all of your hard work has been worth it.
If the return you are receiving on the money invested in your company does not at least equal the return you would receive from a risk-free investment (such as a bank CD), this could be a red flag.
Return on Investment = Net Profit Before Tax ÷ Net Worth
Summary: How to Assess Business Growth with Gross Profit
The evaluation of your bottom line should go beyond more than looking at your bank account. Successful business owners know that a company’s ability to succeed in the future is not measured by how much money is in the bank. Instead, the true meaning of financial health comes from analyzing your business activities and utilizing your profits wisely..
Make sure your business is operating efficiently and regularly use the profitability ratios we covered to ensure you’re on a path to success.