Using Profitability Ratios to Better Understand Your Business

by Greg DePersio

2 min read

Profitability ratios are accounting ratios that can help any small business owner better understand important aspects of his or her business. Here are examples of five different profitability ratios that any small business owner can use.

What Are Profitability Ratios?

Profitability ratios compare different accounts to see how efficiently a business is generating profits. These ratios show how well income is generated through operations, and are important to both creditors and investors. They help determine the company’s ability to continue operating.

Gross Margin Ratio

This ratio compares a company’s gross margin to its net sales. It shows the level of profits a company earns from the sale of its products or services. It is calculated as:

Gross margin ratio = (revenue – cost of goods sold) / revenue

For example, if a company has $500,000 in revenue and $200,000 in cost of goods sold, the gross margin ratio is:

($500,000 – $200,000) / $500,000 = 60%

The gross margin ratio is not the same as the profit margin ratio. Gross margin only considers the cost of goods sold expense, while profit margin considers other expenses.

Profit Margin

The profit margin measures the amount of net income earned with each dollar’s worth of revenue. It shows the percentage of sales that remain after all of the company’s expenses have been paid. The higher the ratio, the better. It is calculated as:

Profit margin = net income / net sales

For example, if a company has $500,000 in revenue, $200,000 in cost of goods sold and $150,000 of other expenses, the profit margin is:

($500,000 – $200,000 – $150,000) / $500,000 = 30%

Return on Assets Ratio

This ratio measures the net income produced by the company’s total assets over a period of time. It measures how efficiently a company utilizes its assets to generate profits. It is calculated as:

Return on assets = net income / average total assets

For example, assume a company has $100,000 in net income over the year. Its beginning assets were $500,000 and its ending assets were $600,000. The return on assets is:

$100,000 / $550,000 = 18.2%

In all cases, a higher ratio is more desirable.

Return on Capital Employed

This ratio measures how efficiently a company can generate profits from the capital employed, which takes into account equity and long-term liabilities. This is a long-term profitability ratio. Instead of net income, the ratio uses operating profit, often called EBIT. The formula is:

Return on capital employed = EBIT / (total asset – current liabilities)

If the ratio value equals 0.25, this means the business generates 25 cents for every dollar of combined equity and long-term liabilities. The higher this ratio, the better.

Return on Equity

Similar to the above ratio, return on equity shows a company’s ability to generate profits from its investors’ capital. It is calculated as:

Return on equity = net income / shareholder’s equity

The higher the value of this ratio, the better for the company and its investors.

References & Resources

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