Profitability Ratios: What it Is and Why It Matters

Published on Aug 3, 2020 | Small Business

Calculating the company’s profitability ratios is one of the most effective ways for entrepreneurs to measure their success. If you’ve been in the business long enough, then you might have a good grasp of it. But for others that are still in the early stages of their ventures, it’s one that they should concern themselves with.

Knowing the ins and outs of business profitability can be one of the most daunting things that a start-up entrepreneur has to go through. But, it’s also important to note that these ratios are vital in the investment journey of businesses. As entrepreneurs fully understand the concept of it, they will eventually appreciate why it matters in their businesses.

Profitability Ratio Definition

Profitability ratios are among the financial metrics used to evaluate a company’s performance when it comes to generating profits in relation to their revenue, balance sheets, operating costs, and investor’s equity during a specific accounting time in the business. It shows entrepreneurs and the investors how efficient the company is in utilizing their assets to come up with an income.

Entrepreneurs want to make sure that their business is doing well when it comes to returns in their business. That is why it is necessary to calculate and analyze the company’s profitability ratios. The ratios are usually compared to the ones from the previous quarter and of those companies within the same industry. Essentially, the higher your profitability ratio is compared to previous values or competitors, the better your company’s performance is in that particular period.

Two Types of Profitability Ratios

Companies use two categories of profitability ratios in their financial analysis: margin and return ratios. By analyzing these two, the business owners can have a bigger picture of a company’s financial health and performance. It can also help the firm’s managers and investors answer the following questions:

    • Is the company’s performance getting better or worse?
    • How is your company doing in terms of generating an income?
    • Is it possible for your business to perform better?
    • How is your business doing in comparison to other businesses?

Margin Ratios

Margin ratios measure how efficient businesses are in turning their sales into profits. It tells the business owners how well the business is in handling their sales and other finances.

Margin ratios are further divided into three categories: gross profit margin, net profit margin, and operating profit margin.

Gross Profit Margin (GPM) Ratio

Gross profit margin, or GPM, is one of the first financial metrics that businesses compute to analyze their sales. The GPM measures the business efficiency in using labor and materials in producing their goods. It tells the business owners how profitable the goods or services are after taking into account the cost of goods sold (COGS). In service companies, they use the cost of revenue instead of the cost of goods sold.

A higher gross profit margin percentage indicates that a company has a lot of money left to pay for its operational expenses. With more money, they can cover employees’ payroll, rent, and utilities. The GPM percentage can also show how much money is available to fund vital parts of the business.

In calculating the gross profit margin, all you have to do is to calculate the gross profit and net sales. From there, the gross profit, then, is divided by net sales. The quotient is then multiplied by 100 to get the percentage.

For instance, a business generated 10,000 in sales in one year and a gross profit of $5,000. Based on the formula, we can get 50% as gross profit margin. What this means is that for every dollar earned, 50% of it goes to their profits while the other 50% is what they spend in the production costs.

Net Profit Margin

The net profit margin, otherwise known as the profit after tax (PAT), reveals the percentage that is left from the revenue after all the total expenses are deducted. It is sometimes the most commonly used margin ratio in profitability ratio analysis. However, it’s not considered as precise as the other metrics because it takes into account other aspects and not just the company’s core business.

The net profit margin can be calculated by dividing the net income by the net revenue, or net sales. For instance, an entrepreneur generates a sale of $15,000 in sales and used $10,000 in his production costs. Using the formula, we get a 66% gross profit margin ratio. This means that for every dollar generated, they gain $0.66 in profit.

Like the gross profit margin, higher profit margins indicate a more successful and efficient business operation. It implies that the business is doing a great job in managing the expenses and pricing of their goods or services.

Operating Profit Margin

Operating profit margin, or earnings before interest or taxes (EBIT) takes into account the profitability of the company before taxes, amortization, interests, and other non-operating expenses.  This financial metric is more accurate as it considers not only the loss incurred in sales but also the overhead and marketing costs. The benefit of using operating profit margin is that it’s much easier to compare to other industries since it doesn’t include variable costs.

To calculate the operating profit margin, you only have to divide your operating profit by your net sales. You can get the percentage by multiplying the quotient with 100.

For example, a business generated a sale of $20,000 in one year. Their operating income is up to $100,000. Using the formula you can get a result of 20% as their operating profit margin. This means that for every dollar, they get up to 0.2 cents in expenses before tax and interest.

In reality, each industry may hold a different standard when it comes to profit margins. Since they have different financial structures, it’s expected for the profit margins to differ, as well.

Return Ratios

The other ratio used in profitability analysis is the return ratio. It represents the returns the company generated for its investors or shareholders. There are three types of return ratios used in profitability ratio analysis: return on assets, return on equity and return on invested capital.

Return on Assets (ROA)

Return on Assets (ROA) talks about how efficient a company is in managing their assets and using it to generate profits. It shows the earnings relative to the total assets that the company owns after accounting all costs, expenses, and taxes. In the simplest sense, ROA shows how much profit the company collected for every dollar it owns.

To calculate ROA, you have to know the average total assets first as well as the company’s net income. Both of these are found on the company’s balance sheets. Once you have that, divide the total net income by the company’s average total assets. The resulting number is your company’s ROA. Like other ratios, ROA is usually expressed in percentage.

The more asset the company owns, the more profit it can generate. Telecommunications and construction companies usually require large investments for their equipment and machinery. As such, they’re considered as highly asset-intensive companies. That said, they may generate more profit than those companies that are less asset-intensive such as marketing agencies. But then again, the standard may differ among industries. Just because highly-intensive companies generate more profit doesn’t mean that less asset-intensive companies are not that profitable.

Return on Equity (ROE)

Unlike return on assets, return on equity compares the profitability of the company to the shareholder’s investments. ROE is calculated by dividing the net income of the company by the total equity of the company’s shareholders. The resulting number is the percentage of ROE. It is one of the information that potential investors use to assess whether your company is worth investing in or not.

Return on equity (ROE) measures the ability of the company to turn the shareholder’s investments into profits. A low ROE implies that the business is performing poorly in utilizing its shareholder’s equity to generate returns.

While it’s easy to think that greater ROE usually means good performance, it isn’t always the case. A big increase (double or triple) in the ROE usually indicates a risk. It could mean inconsistent profits, too much debt, or a negative net income. Whatever the case is, too little or too much ROE should be a cause for concern for business owners.

Return on Invested Capital (ROIC)

Return on invested capital is another financial metric that businesses use in tracking their company’s profitability. The ROIC measures the return the company received in relation to its capital. It gives a sense of how the company is performing in terms of allocating their cash flow to gain profits.

In calculating the ROIC, you’ll need the values of the company’s net operating profits and the invested capital. Divide the net operating profits by the invested capital and you’ll arrive at a number which will represent your company’s ROIC.

A company’s return on invested capital indicates the amount of return a company received for every dollar of its working capital. Ideally, the company should have an ROIC of 2% or higher. This will show investors that your company is profitable. In contrast, an ROIC of less than 2% can discourage investors. In this case, the company may need to assure investors with a potentially profitable plan in the future.

Why is Profitability Ratio Analysis Important for Businesses?

All businesses have one goal: to make a profit. The only way they can determine whether they’re heading in the right direction or not is to compute their profitability ratio. The resulting values, then, provides entrepreneurs with enough information regarding the financial state of their company.

Aside from that, here are other reasons why every entrepreneur shouldn’t overlook the importance of profitability ratio analysis:

1. Increases Your Chances of Business Loan Approval

Every business will need additional financing at some point. But before they can get it, credit analysts, like banks and lenders usually look at your profitability ratios to determine your eligibility for business loans. They can assess whether the businesses are generating enough profit and ensure that the company can pay their debts on time.

Related: 7 Tips to Increase Your Chances of Small Business Loan Approval

2. Detects What Aspect Your Company You Need Improvement in

Though a company’s financial statements can give important insights into the financial standing of the company, it doesn’t give out the whole picture. Coupled with the company’s profitability ratios, the managers can know what aspect of the business needs more work. With that, the team can redirect its focus towards that direction and improve the company’s performance altogether.

For instance, lower gross profit margins compared to the previous quarters can imply that a problem exists in your cost of goods sold. The company, then, shifts its efforts to improve that part of their business.

3. Draws Investors into Your Business

As a company grows, their needs also grow with them. While business loans can give them the additional working capital they need, they sometimes need more cash to move forward with their bigger plans. With that, they have to attract willing people to invest in their venture.

Aside from that, people who are looking to invest in businesses also look at the profitability ratios first before proceeding to purchase. They usually seek the help of stock analysts to help them with their decision. Since the investors face a big risk in purchasing stocks, entrepreneurs might as well make sure that their investors made a good choice. Thus, they have to aim for a better and assuring profitability ratio.

Moreover, good profitability ratios can help convince a company’s current shareholders to stay in your company. As long as the company stays profitable, they won’t have a reason to withdraw their investment. This, in turn, maintains the financial stability of the company.

4. Makes it Easier for Companies to Compare their Performance to Other Companies

It’s understandable for start-up companies not to earn as much compared to their more established counterparts. However, through profitability ratios, small business owners can determine where they stand as opposed to their competition.

Ways to Improve Your Business’ Profitability

Businesses can experience dips in their business’ profitability. However, this shouldn’t discourage them in achieving success. There are a lot of things they can do to restore their profitability, and maybe even more. Here are some ways on how they can do it:

1. Cut Costs

Start-up companies usually experience dips in their profitability during the first few quarters of their operation. As a remedy, they cut back on some costs while making sure not to sacrifice the quality of their goods or services. In doing so, they usually assess these areas they can cut back on:

    • Financing options. Sometimes, the rate or terms of your business loans can bring the profitability of your business down. Higher interest or fees forces companies to cash out a huge chunk of its much-needed money to repay their debt. But, by negotiating better terms, the company can save large sums and increase their profitability.
    • Vendors or suppliers. A lot of suppliers often offer discounts to customers who buy in bulk. Companies, in turn, can take advantage of this and save some bucks along the way.
    • Looking for cheaper materials to use in the manufacturing process can make a big difference in reducing production expenses. Companies can also streamline other tasks to save time and labor costs.
    • Office Space. If there’s still some space left unused in the office, entrepreneurs can take the opportunity to sublet it to other businesses. This way, they won’t have to carry the burden of paying for the expensive rent.

Related: 6 Practical Tips to Effectively Stick to a Business Budget

2. Improve Inventory Visibility

Sometimes, too much inventory can bring a company’s profitability ratios down big-time. That is why businesses need to have better control of their inventories. For instance, entrepreneurs should avoid, if not eliminate, stocking up on products with a slow-turnover rate. This lessens their chances of getting their money tied up on products that don’t sell.

3. Reconsider Your Pricing

Underpricing your products or services Changes can happen all the time in businesses. With that, prices for specific products can go up, as well. This is why entrepreneurs need to stay up to date with the changes in the prices. This helps avoid underpricing which can take a huge toll on their business’ profitability.

4. Attract More Customers

While it might be more cost-effective to keep your current customers, it’s also important to expand your customer base to boost your sales. Additionally, selling to your new customers is easier, especially if you’ve recently increased your prices. Once you have covered the existing market, plan on moving on to another niche.

5. Increase Employee Productivity

Estimates show that 67% of all salespeople don’t reach their target quotas, thus bringing the company’s profitability down with them. As all entrepreneurs know, sales are important to generate revenue. With that, entrepreneurs must create a better and more efficient sales process. This will help the staff perform better in their respective assignments leading to an increase in the overall sales performance.

Your Profitability Ratios Matter

Profitability ratios are among the most important financial metrics that the majority of the businesses use to track their profits. These percentages can tell so much about the current standing of your business finances. Aside from that, it can help you attract investors that are vital to your company’s financial success.

Given how competitive the companies are today in different industries, companies must increase their level of efficiency to keep up. By analyzing different financial metrics regularly, entrepreneurs can formulate concrete ways for their company to stay in the game. That in turn, increases their chance of staying profitable and sustainable in the long run.

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