What are profitability ratios?

Profitability ratios are a set of metrics used to analyse a business’s financial health. Whether you focus on your gross, margin, or net ratio, these numbers will show how much of a profit your business could turn at a certain moment in time.

If you’re a business owner, profitability ratios can give you some insight into how stable your company is and how easy it would be to secure an investment. But like a lot of financial metrics, profitability ratios aren’t much use if you take them in isolation. In this post, we’ll look at how to calculate profitability ratios accurately, how to use them in your planning, and how to improve them over time. 

How are profitability ratios calculated?

A business’ profitability ratio shows the earnings it could generate from its sales or the services it provides. Specifically, the ratios measure potential earnings relative to: 

• Your revenue
• Your operating costs
• The assets on your balance sheet 
• Shareholder equity (if you have shareholders). 

So, to figure out any of your profitability ratios, start by looking at your financial records to get an up-to-date picture of those numbers. 

There are two types of profitability ratios: margin and return. 

Margin ratios

Margin ratios are usually the most relevant for small business owners. They show how efficiently your company can turn sales into profit. When you do the full set of margin ratio calculations, you look at your business’s profitability from different angles to get a fuller picture. 

• Gross profitability ratio:  This is probably the profitability ratio you’ll examine first. It tells you the difference between your sales revenue and the cost of goods sold (COGS), which boils down to the cost of production. 
• Operating profitability ratio: Operating profit is a way for business owners to look at their earnings after accounting for more of their operational costs (not just COGS). It also takes account of essential outgoings like payroll, business insurance, utilities, marketing, and your rent or mortgage payments. 
• Net profitability ratio: Your net profitability is essentially the money you take home once all the deductions are accounted for. This shows your business’s income after COGS, the rest of your expenses, and your taxes. It also factors in other sources of income, like money from the sale of assets or returns from investments. 

Profitability ratios are given as percentages – specifically the percentage of the company’s revenue that’s considered profit. 

So, to calculate a profitability ratio, you take your revenue and subtract your outgoings: COGS for gross profitability, operating expenses for operating profitability, or all your outgoings for net profitability. Next, take this number and divide by your revenue. Finally, multiply by 100 to get the percentage. 

For example, the calculation for gross profitability ratio is: 

(Revenue – COGS) / Revenue = Gross profitability ratio

In real terms, imagine you ran your own small cleaning business and made £50,000, spending £20,000 on supplies, equipment, and transportation. Your gross profitability calculation would look like this:  

(50,000 – 20,000) / 50,000 = 0.6 

0.6 x 100 = 60% Gross profitability ratio

Remember, this doesn’t include other essential costs like your public liability insurance or your taxes. For that, you’d have to calculate your operating and net profitability ratios too. Both of these will be considerably lower.  

Return ratios

Return ratios won’t be relevant if you have a new business or a small business that doesn’t have shareholders. But let’s take a quick look at what these metrics measure, to give you an idea of the range of profitability ratios you might be asked about: 

• Return on assets profitability ratio: This metric looks at a business’s profitability relating to its assets. It’s based on the assumption that the more assets a company has, the greater its potential earnings. 
• Return on equity profitability ratio: Shareholders are particularly interested in return on equity, as it shows the company’s ability to return a profit on the money they’ve invested.
• Return on invested capital profitability ratio: This ratio is similar to ROE, but takes account of capital from a range of different sources.

Margin and return ratios both show how effective a company’s management decisions have been. Margin ratios show how well a company is controlling its costs. Return ratios show how well a company is managing the investments its shareholders have made. 

In both cases, higher ratios are seen as a sign of a financially healthier business.

How do businesses use profitability ratios? 

Business owners can use profitability ratios in a few different ways: 

• To look at their financial performance from different angles. It’s always helpful to know both your gross and net ratios, for example, to judge whether your business expenses have been too high, or whether it’s time to raise the price of your goods or services. 

• To see how well your business is faring in the current economic conditions.

If your ratios are high and steady, it’s a sign you’re in a better position to weather economic downturns than your competitors. 

• To plan for expansion. 

As well as business owners, banks and investors look at profitability ratios to measure the risk they’d be taking if they lent to or invested in a company. When you know your ratios, you can find areas for improvement before you scale your business up and generally prepare for these high-stakes meetings. 

Having said this, it’s also important to know that profitability ratios alone won’t give you all the information you need about your business’s financial health. They’re most useful when: 

• They’re used as a set rather than a standalone figure
• They’re tracked over time rather than used as a snapshot  
• They’re used to compare one business to another in the same region and industry, rather than being taken in isolation. 

Think again about your gross profit, for example. 

A high gross profitability ratio means you’ve generated a good amount of revenue from your sales while keeping the cost of materials under control. But it’s possible to have a high gross profitability ratio and a low operating profitability if a lot of your gross profit is being swallowed up by managing your business premises inefficiently. For example, you might be employing too many people during a time when there’s low demand for your services.  It’s possible to miss if you focus too much on one metric. 

Likewise, your net profitability ratio might be higher than last year, but since this metric also includes one-off expenses and sources of income (like selling assets), the ratio can be skewed. A high ratio in one year is no guarantee of an upward trend if you don’t take account of those exceptions. 

Finally, your operating profitability ratio might be lower than some other businesses in your sector. But businesses can be more seasonal in different parts of the country, and costs like rent can vary from city to city. This means this profitability ratio is only a useful comparison tool if you look at the trends over time and compare your metrics to a specific set of competitors with these differences in mind.  

How to improve profitability ratios for your business

Business owners always want to see their profits or profitability ticking up. If you want to do more to meet your goals, it’s simple (at least on paper) to improve your metrics over time. 

To improve your gross profit (your revenue minus COGS), you focus on: 

• Raising the price you sell your product or service for
• Lowering COGS, for example, by renegotiating or finding less expensive suppliers to lower the cost of production. 

To improve your net profitability ratio, you:

• Increase your gross profit (in the ways discussed above) 
• Lower your other business expenses, for example, by moving to less expensive premises, leasing equipment instead of buying it, or renegotiating contracts for your utilities, business insurance, etc. 

Before you make changes to the way you run your business, make sure that you’re working with accurate figures. A mistake in your balance sheet can play out in your profitability ratio calculations and leave you with a flawed picture of your business’s financial health. 

That’s why it’s so important to keep your financial records up to date and follow standard accounting practices. Plus, if your goal is to improve your business’s financial health ahead of an expansion, you’ll be ready to show the figures to your bank so they can start their due diligence straight away. 

Profitability ratios: quick recap

When we speak about profitability ratios, we mean a whole range of different figures. Pieced together, they can help you understand how financially stable your business has been over time, how much risk it represents to a bank or investor, and which areas you need to focus on if you want to put yourself on a stronger financial footing. 

It pays for small business owners to track their gross, operational, and net profitability ratios regularly, so they can identify patterns and get a more accurate picture of their business’s growth and performance.