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What are profitability ratios?

Understanding your businesses finances requires some clever calculations, and that includes profitability ratios. These ratios are the key metrics you need to get insight into how well your business is generating income. Many of the ratios also need to be used in tandem to give the clearest possible history of your company’s financial health. Here’s our guide on some of the key ratios you need to know about, and how to use them.

Gross profit ratio

The gross profit ratio is used, as the name implies, to find your gross profit margin, arguably one of the most important figures to your business. By using the gross profit ratio formula, you can calculate a figure which shows what your business makes after costs such as operations and COGS have been taken into account. You should aim for a high gross profit margin as this means your operation efficiencies are good. The gross profit ratio formula is:

(Revenue – COGS) / Revenue             

Net profit margin ratio

The net profit margin ratio formula shows your net profit, i.e., how much of your revenue is profit. This ratio is similar to the above gross profit ratio, with the key difference being that it considers things like expenses, debt payments, and other income. Essentially, the net profit margin ratio shows your ability to turn your income into profit. The net profit margin ratio formula is:

(Net Income / Revenue) x 100

EBITDA margin

The EBITDA margin shows a business's operating profit. EBITDA stands for “earnings before interest, taxes, depreciation and amortization”. Removing these factors from your calculations gives you a figure that is a useful tool when it comes to comparing your performance to competitors. The formula is:

(Earnings Before Interest and Tax + Depreciation + Amortization) / Total Revenue

Operating profit margin

The operating profit margin shows you what your business earns on sales before things such as interest and tax are considered. A higher operating profit margin generally means you are in a better position to offer lower, more competitive prices to your customers. It can also help you understand how well your company is being managed, as a high operating profit margin suggests optimized efficiency and therefore, solid management. The operating profit margin formula is:

Operating Earnings / Revenue

Return on investment (ROI)

As well as money in, businesses need to know what money is going out, and how it might bring them returns. That’s where the ROI becomes a very important calculation in your profitability ratios. The ROI formula can be used to work out what an investment is likely to make, relative to its cost. The formula for this is:

(Current Value of Investment – Cost of Investment) / Cost of Investment

Return on Assets (ROA)

Your return on assets calculation can show you the profitability of your business relative to your total assets. Essentially, it shows how good your business and its management is at driving profit through efficient use of your assets. This is one of the profitability ratios that investors will look at when considering your company. The formula to ROA is:

Net Income / Total Assets

Return on equity (ROE)

It’s not just business owners and their accountants that use profitability ratios, investors will also use them to see where they want to place their money. The return on equity ratio is one of them, and helps investors understand if they will see a healthy return from one company versus another.

Net Income / Shareholders’ Equity

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