People are often advised to do “the best they can with what they have,” and the same goes for businesses. Profitability ratios are one way for investors to measure just how well a company is doing given its available resources.
What Is a Profitability Ratio?
A profitability ratio is a metric that allows an investor to quantify how efficiently a company produces profit using various resources. Many different profitability ratios exist, and each has a different focus.
By comparing the profitability ratios of similar companies, investors can attempt to identify the most financially efficient players within a given industry. Similarly, an investor can look at a single company’s profitability ratios from different periods to discern whether the business is becoming more or less efficient at generating profit over time.
Ideally, investors should look at a suite of different profitability ratios in order to gain a more holistic understanding of exactly how a company translates its resources into profit compared to its industry peers and its past performance.
Since some measure of profit (often called net income or earnings) is usually the divisor in a profitability ratio, higher results are considered favorable. If a company’s gross profit margin (the most commonly used profitability ratio) goes up over time, for instance, this could indicate that the company is lowering production costs in such a way that it makes more profit from each sale.
What Are the 2 Types of Profitability Ratios?
Most profitability ratios fit into one of two general categories—return ratios and margin ratios. Margin ratios focus primarily on how well a company generates profit from sales, so the denominator in their calculation is always revenue. Return ratios are a little different, as they compare profit to investor equity, company assets, or invested capital.
| Margin Ratios | Return Ratios |
|---|---|
Gross profit margin |
Return on assets |
EBITDA margin |
Return on equity |
Operating profit margin |
Return on invested capital |
Net profit margin |
— |
Cash flow margin |
— |
8 Common Profitability Ratios & What They Mean
Different ratios provide insight into different parts of the profit-generation process. The following are some of the most popular among investors.
Gross Profit Margin
Gross Profit Margin = (Revenue – Cost of Goods Sold) / Revenue
Gross profit margin is a simple and popular measure of how much profit a company generates from its sales. Cost of goods sold, which represents the direct costs associated with producing a good (usually materials and labor) is subtracted from revenue. The result is then divided by revenue and is then typically expressed as a percentage.
Cost of goods sold does not include distribution costs, sales force costs, or administrative expenses, and for this reason, gross profit margin is most useful in determining how efficiently a company maximizes profit by minimizing production costs.
EBITDA Margin
EBITDA Margin = Earnings Before Interest, Tax, Depreciation & Amortization / Revenue
EBITDA stands for earnings before interest, taxes, depreciation, and amortization. The EBITDA margin is a profitability ratio that divides EBITDA by revenue to express how profitable a company is from an operational standpoint, without taking into account the types of expenses that can be particularly variable from one period to the next.
Because the EBITDA margin omits volatile non-operating costs, it is a good way to compare the profitability of similar companies in an industry without results being skewed by abnormally high or low interest, tax, depreciation, or amortization costs.
Operating Profit Margin
Operating Profit Margin = Operating Income / Revenue
Operating profit margin—often referred to simply as operating margin—is similar to EBITDA margin in that it excludes interest and tax costs. Unlike the EBITDA margin, it does include depreciation and amortization. For this reason, it can also be referred to as EBIT margin.
Operating margin is particularly useful in evaluating a company’s ability to reduce operating costs compared to its industry peers.
Net Profit Margin
Net Profit Margin = Net Income / Revenue
Net profit margin, commonly referred to as the “bottom line,” can be thought of as real profit. Net income is revenue minus operating expenses as well as interest and tax payments and depreciation and amortization costs. For this reason, a company’s net profit margin should always be the lowest of its margin ratios.
Net profit margin is probably the best measure for comparing the current profitability of different companies within an industry or market.
Cash Flow Margin
Cash Flow Margin = Operating Cash Flow / Revenue
Operating cash flow is calculated by adding non-cash expenses (depreciation and amortization) to net income along with the change in working capital (whether positive or negative) for the period in question. This is then divided by revenue to produce cash flow margin.
In other words, cash flow margin is a way to express how efficiently a company turns sales into cash for ongoing operations.
Return on Assets (ROA)
Return on Assets = Net Income / Total Assets
Return on assets expresses a company’s net income (profit) as a percentage of its assets. This metric is useful in analyzing how well a company uses its assets (the things it owns, like property, plants, equipment, patents, etc.) to generate profit.
Return on Equity (ROE)
Return on Equity = Net Income / Shareholders’ Equity
Return on equity expresses a company’s profit as a percentage of its shareholders’ equity (the difference between its assets and liabilities, or its net worth). This metric is useful in showing how efficiently a company is able to generate profit using the money investors put into the business in exchange for stock.
Return on Invested Capital (ROIC)
Return on Invested Capital = Net Operating Profit After Tax / Invested Capital
ROIC is similar to ROE, but it takes bonds into account as well as equity. It is a more holistic measure of a company’s ability to produce profit using investor money.
