Profitability doesn’t happen by accident. Maintaining it takes careful planning, timely execution, and a firm grasp of the factors that affect income and expenses. Profitability ratios are tools that make that possible. As companies scale, the income statement provides the data needed for this analysis. Margin ratios are used to measure efficiency. Return ratios tell shareholders and business owners what the company can generate for payouts and dividends.
What are profitability ratios?
Profitability ratios are mathematical equations that are applied to each level of the income statement to determine where the company is efficiently generating revenue and where it may be falling short. There are four levels of inquiry in this process:
- Sales: Total sales revenue before any expenses
- Gross profit: Net sales minus cost of goods sold (COGS)
- Operating income: Gross profit minus operating and administrative expenses
- Net income: Total net income after all expenses have been deducted
Each of these categories is a line item on the income statement, so the numbers are easy to find. Profitability ratios measure the margins at each level. For instance, gross profit divided by net sales revenue gives you the gross profit margin. The ratio expresses that number as a percentage. Operating income divided by net sales gives you the operating profit margin.
Margins aren’t the only thing that profitability ratios are good for. They can also be used to calculate the return on equity investment (ROE) and the return on assets (ROA). These numbers are particularly important to business owners and shareholders because they measure how much will be available for personal profit or dividend payouts.
Practical uses for margin and return ratios
All business ratios tell a story. With profitability ratios, that story is all about how the company is making money and what it costs them for every dollar they bring in. In this section, we’re going to tell you the tale of “Company B,” a hypothetical firm that sells machine parts. Their income statement contains the following line items.
- Sales: $500,000
- Gross profit: $250,000
- Operating income: $50,000
- Net income: $11,250
To get the gross profit ratio, divide gross profit ($250,000) by sales ($500,000) and multiply that number by 100. The result is 0.50, meaning this company made a gross profit of 50%. That would be pretty good, if there were no other expenses. The operating ratio is just 10% and the net income ratio is 2.25% after all expenses and taxes have been paid.
Is “Company B” a profitable company for owners and shareholders? You’ll need some data from the balance sheet to find that out. The ROA ratio is net income divided by the average of total assets for the year. The ROE is the net income divided by the average of total equity for the year. Here are the numbers to do those calculations:
- Average assets: $225,000
- Average equity: $56,250
Averages can be calculated by taking the balance at the beginning of the year, adding it to the balance at the end of the year, and dividing by two. In this example, we’ve already done the math for you. With a net income of $11,250, the ROA ratio is 5% and the ROE is 20%. That’s a healthy mix. Your shareholders are getting a nice return.
How does this help your business grow?
Profitability ratios can reveal mistakes from the past, help you operate more efficiently in the present, and provide a roadmap for future growth opportunities. For instance, if gross margins are high but net profits are down, look for areas where you can cut expenses and overhead. Streamlining based on the data in the income statement will improve profitability.
Increased profitability fuels growth. A high return on assets means that your company is operating efficiently without the need to take on new debt. A high ROE means your shareholders are getting paid and chances are your stock price is up. That’s a growth metric that could attract new investors if you choose to go that route.
Would you like to know how you rank against your competitors? This is how companies are measured inside their respective sectors. Profitability ratios tell us more than stock prices, balance sheets, or sales numbers. They break down how revenue is generated, which costs affect your bottom line, and how much you and your shareholders will get paid.