Starting your own venture can be risky business. A third of startups fail; while there are many reasons SMBs conk out, one of the top causes is having poor cash flow.
Inadequate financial management often stems from financial illiteracy, which can disproportionately affect minority small-business owners. A potential solution is for founders to invest more time in educating themselves about business finance.
One important metric is profitability ratios, which help investors, bankers, and entrepreneurs gauge the health and sustainability of the business, and gain insight into the efficiency of its operations.
What are profitability ratios?
A profitability ratio is a metric business owners, analysts, and investors use to better understand a company’s financial well-being. It evaluates the business’s ability to make a profit from its revenue.
Its purpose is to determine whether a company is growing, declining, or stagnating, and to identify whether it’s properly using its assets to gain returns for shareholders.
There are several types of profitability ratios, including gross profit margins, operating profit margins, and return on assets.
Why are profitability ratios important?
It depends on whom you ask. For instance, from an investor’s standpoint, profitability ratios show whether a company’s worth betting on.
If a business is on a long-term incline, odds are it’ll continue to turn a healthy profit, making it a good investment. If the opposite is true, then it’s a red flag and considered a risk.
But profitability ratios aren’t essential to just analysts and investors. It’s a useful tool for business owners. For example, you can use it to:
- Compare your business to competitors. Profitability ratios show the business’s efficiency and sustainability, so you can determine if you need to improve your operations.
- Identify underlying issues eating away profits, such as bureaucratic processes reducing productivity or overspending.
- Pinpoint seasonalities in profit.
- Determine if a business strategy is helping or hurting your company’s growth, and make more informed decisions as a result.
What do profitability ratios measure?
Profitability ratios use formulas to determine whether a company is turning a profit over a specific period. You can use them to review your company’s financial performance over months, years, or even decades.
To calculate this, profitability ratios use various metrics like:
- Net and gross profits
- Cost of goods sold (COGS)
- Business expenses
- Operating costs
- Cost of assets
- Return on assets
You can find many of these on your profit and loss statement, depending on the type you use.
What’s included in a profitability ratio formula depends on what you’re trying to calculate. For example, if you want to know whether a company’s making returns on a new asset it purchased, then you’d take the cost of assets into account.
Whichever ratio you use, it’s ideal to compare two or more time periods (i.e., contrasting this year’s profits to last year’s).
Profitability ratios are also a tool credit companies use when determining lending. For instance, Creditsafe, a credit risk platform, uses a company’s historical financial performance as a key indicator when creating credit reports.
And while profitability ratios are a helpful indicator, they vary depending on the life cycle of the business.
“It’s common for startups to be loss-making in their first year, so rather than looking at profitability ratios, a credit manager would assess other metrics, such as customer acquisition costs, lifetime value, and customer retention — as well as the obvious cash flow and net expenditure,” says Matthew Debbage, COO of Creditsafe.
Examples of profitability ratios and their formulas
There are several types of profitability ratios you can use to gauge the well-being of your business. These ratios fall under two umbrellas:
- Margin ratios: Shows if a business is generating a profit from sales
- Return ratios: Shows if a business is generating profits for shareholders and owners
Here’s an overview of the most commonly used profitability ratios for small businesses.
Gross profit margin
Gross profit margin measures a company’s income after paying for COGS (e.g., inventory, labor, storage fees, materials). A business with high gross margins will have more leftover to go toward other expenses.
If the gross profit margin is high — and your expenses, debts, and taxes are low — then it’ll yield greater profits for shareholders and owners. If the margin’s low, then the opposite is true, and you may end up losing money.
Sometimes a company has massive gross profit margin fluctuations. This is a red flag indicating an issue with poor management or product quality. It can also occur when a business makes drastic operational changes.
For example, switching to a manufacturer that produces a lower-quality product, creating a surge in returns. Or eliminating a service customers loved, such as free home deliveries, causing them to switch to a competitor.
The formula: Gross Profit Margin = (Total Revenue – Cost of Goods Sold) ÷ Total Revenue x 100
Here’s an example:
A multivitamin supplement business sold $70m in goods and spent $60m in COGS, generating a $10m gross profit.
Gross Profit Margin = ($70m - $60m) ÷ $70m x 100
Gross Profit Margin = 14%
This means the business keeps $0.14 of every dollar earned in revenue. However, this doesn’t include what it must spend on taxes and expenses (operating and nonoperating).
Operating profit margin
Operating profit margin requires calculating your gross profit ratio first. Once you have that, deduct your operating expenses, such as commissions, administrative costs, salaries, rent, and office supplies or equipment.
Some use operating profit margin to gauge if the company adapts to seasonal slowdowns (e.g., restaurant and hospitality industries). This ratio shows your business can thrive during downturns while maintaining operational expenses.
Since operational expenses occur daily, you may need to cut back when needed to maintain profitability in cyclical industries. For example, if you own an ice cream shop, ordering fewer ingredients during the winter will likely prevent waste and lost revenue.
A sound operational profit margin shows investors the business owner has good financial sense and the company’s model is sustainable.
The formula: Operating Profit = Gross Profit - Operating Expenses
Then: Operating Profit Margin = (Operating Profit ÷ Total Revenue) x 100
In the real world, it may look like this:
The multivitamin supplement brand from our last example has a $10m gross profit and $2m in operating expenses. So the formula would look like this:
Operating Profit = $10m - $2m = $8m
Operating Profit Margin = ($8m ÷ $70m) x 100
Operating Profit Margin = 11%
This means the business retains $0.11 for every $1 it generates in revenue.
Net profit margin
Net profit margin measures a business’s money after paying for operating and nonoperating expenses, such as loans. It shows whether a business is making enough money to pay back its debts and while maintaining operations.
The formula: Net Profit Margin = (Net Profit After Tax ÷ Total Revenue) x 100
A real-world example of calculating net profit margin may look like this:
The multivitamin business earned $70m last year and is currently at $8m in operating profit. Now, deduct taxes and loan interests, which total $2m. Here’s how the calculation of the net profit margin would look:
Net Profit Margin = ($6m ÷ $70m) x 100
Net Profit Margin = 8%
So for every dollar earned, the business keeps $0.08.
“[Net profit margin] provides major insights into your business because it accounts for all expenses your business incurs. It’s also useful when analyzing and estimating marketing spend,” says Forrest McCall, finance and investing expert.
Return on assets
Return on assets (ROA) is a return ratio, which determines if a company’s generating profits after investing in assets, such as real estate, machinery, and other equipment or supplies. It can also help indicate if asset investments are making a return by improving your operations.
This in turn tells investors and lenders that your business is capable of using its resources and assets to make money. So the higher the percentage, the better the business is doing.
To calculate your return on assets ratio, take your net profit and divide it by the total asset costs, then multiply by 100. Here’s how it looks:
Return on Assets = (Net Profit ÷ Total Asset Costs) x 100
The multivitamin supplement business spent $15m in company assets (warehouse, machinery, etc.).
Return on Assets = ($6m ÷ $15m) x 100
Return on Assets = 40%
So for every dollar spent on an asset, the company generated $0.40.
Return on equity
If you’re trying to appeal to investors, then having a positive return on equity (ROE) is just as important as presenting healthy profit margins. Return on equity measures your business’s ability to generate returns for its shareholders.
To calculate, take your net profit and divide it by the average shareholder’s equity. Shareholder equity is how much the investors will get if the company were liquidated and all debts were paid off.
To calculate shareholder equity, take your total assets and subtract total liabilities:
Shareholder equity = Total Assets - Total Liabilities
But to calculate the average shareholder’s equity, you must take the value of shareholders’ equity at the beginning of a period (e.g., January 2022), add it to the shareholders’ equity at the end of a period (e.g., December 2022), divide the sum by 2, then multiply it by 100.
Once you find the average shareholder’s equity, use this formula to calculate ROE:
Return on Equity = (Net Profit ÷ Average Shareholder’s Equity) x 100
Here’s an example:
The average shareholders’ equity in the multivitamin supplement business is $20m.
Return on Equity = $6m ÷ 20m x 100
Return on Equity = 30%
So shareholders receive a 30% return on their investment in the business.
Are some profitability ratios better in certain scenarios?
Yes, some profitability ratios are better for certain businesses and scenarios. For instance, operating profit margin is ideal for seasonal businesses to determine whether they are operating efficiently through high and low seasons.
For early stage startups, margin-based ratios may be best if they haven’t purchased assets or didn’t receive a return on assets yet.
But there’s no one-size-fits-all profitability ratio for a specific business or industry. Instead, you should use multiple to gauge your company’s financial well-being from different perspectives.