Benefits of a Profitability Ratio Analysis

Profit is at the heart of any business, but it’s particularly important for small businesses and start-ups without access to high cash reserves. This makes it a key metric to track over time. There are numerous ways to measure a business’s profitability. Here’s why a profitability ratio analysis is so useful.

What is a profitability ratio?

Before we dive into how to analyse a profitability ratio, let’s look at what it means. There are several types of profitability ratios, all of which are basic calculations designed to give you information about your company’s profit. Five of the most useful include:

1. Gross profit margin

A gross profit margin analysis helps show how efficient your business is. It’s one of the most basic profitability ratios to learn, calculating the amount of revenue left after you’ve subtracted the cost of goods sold. You can then divide this by total revenue and multiple by 100 to arrive at a percentage for easier comparison. A gross profit ratio analysis will typically look at year-on-year, or quarter-on-quarter, changes.

2. Operating profit margin

Operating profit margin analysis measures profitability by deducting both cost of goods sold and operating expenses from total revenue. For the purposes of operating profit margin analysis, it’s best to regularly compare your operating profit margin to past periods, either quarterly or annually.

3. Net profit margin

The third type of profitability ratio involves net profit margin. A net profit margin ratio analysis deducts cost of goods sold, operating expenses, and tax and interest expenses from total revenue. This gives you the most accurate picture of usable profit for your business.

4. Return on assets

In addition to the profit margin calculations, there are different measurements of profit focusing on returns. The first is return on assets, or ROA. This calculates profit generated on assets. To calculate ROA, you simply divide your net profit by total average assets.

5. Return on equity

Similarly, return on equity, or ROE, shows the amount of profit a business generates from its current equity. This type of profitability ratio analysis is particularly useful to investors, who want to see how well a business uses its invested capital to generate profit. To calculate ROE, divide net profit by total shareholder equity.

Why should you perform a profitability ratio analysis?

You can’t make informed business decisions without understanding your financial performance. Yet financial analysis profitability ratios are useful not only for business owners, but also for creditors, investors, and other stakeholders. They give an overview of a business’s financial health, including its return on assets and equity. Generally, higher profit ratios show that businesses are doing well. If ratios are low, this indicates room for improvement. Monitor profit, track cash flow, and find ways to give revenue a boost.

How to analyse profitability ratio

The first step with any profitability ratio analysis is to choose the most relevant ratios. The five mentioned above are the most common. Retailers may wish to focus on gross profit, while SaaS businesses might focus more on operating profit margins. Investors will look at ROE and net profit margins.

Once you’ve determined which profitability ratios to analyse, the next step is to gather past data. Compare current ratios to past ratios and track trends. A year-on-year increase indicates financial health, while a broad spectrum of results shows you need a more reliable business strategy.

Businesses should also compare their ratios to those of competitors to see how they measure up. You’re tracking performance at all levels to see where there might be room for improvement. Do you need to reduce operating costs? Are your assets underperforming? These are the kind of things that analysis will tell you.

How to use these profitability ratio analysis examples

Now that we’ve covered a few profitability ratio analysis examples, how can you put a financial ratio analysis to work in your own business? Improve your business by tracking its performance over time. Understanding your financial performance can drive future marketing and sales campaigns and aid with decision making.

This type of analysis also highlights areas for improvement. Are there operating costs that could be cut to improve your profit margins? Could you automate certain aspects of your business? For example, accounting and invoicing is a labour-intensive area of business that can easily be shifted to online systems.

Payment processing can also be made more efficient using services like GoCardless. We offer merchants a direct debit solution for automating payment collection, saving time and money lost chasing up on later payments. GoCardless also integrates with over 300 partners to streamline your workflow, with full payment visibility from a central dashboard. If you’re looking for ways to improve profitability ratios, this is a great start.

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