What are the Three Main Profitability Ratios and Why Do They Matter?

When a business generates revenue, a portion of that revenue needs to be put back into the company for things like operations costs, payroll, assets, among others. Profitability ratios are metrics that small business owners can use to determine what portion of their generated revenue is profitable, or considered income.

Here are the various types of profitability ratios and what you need to know about them.

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What are Profitability Ratios?

Profitability ratios measure and evaluate a company’s ability to generate income relative to revenue during a specific period of time.

Since profitability ratios measure the company’s financial performance, calculating their metrics allows business owners to strategize and create plans of action to steer the business in the right direction. If ratios indicate that the company’s performance is down, a business owner can develop and implement strategies and budget cuts to increase and bolster profitability. If the company is doing well compared to the previous quarter, the business owner can learn from those positive trends and continue to identify opportunities that will help the company grow even more.

If a company is not a sole proprietorship, its shareholders will likely ask for regular reports about the company’s performance. Profitability ratios provide insight for investors into the company’s financial health.

3 main Profitability Ratios

Profitability ratio is an umbrella term for different types of metrics used to evaluate a company's financial performance. There are many ratios used in business, however, they all fall into these three categories:

Margin Ratios

Margin ratios determine a company’s ability to turn its revenue into profits. You subtract all the business expenses, including raw materials, labor, overhead costs, and others, from the revenue and determine how much of the company’s entire sales have been converted into profits for that specific time frame.

Margin ratios can be further divided into four types: net profit margin, gross profit, and operating profit.

  • Net Profit Margin: The net profit margin subtracts all the expenses related to the company's sales from the revenue. This is the ratio used to represent the company’s earnings after all expenses, including tax and interests, generated during a specific period.
  • Gross Profit Margin: A company’s gross profit ratio talks about earnings that a company has generated in a specific period after the cost of goods sold has been subtracted from the revenue. The cost of goods sold includes the selling and administrative costs of the product or service being sold.
  • Operating Profit Margin: This ratio looks at the company’s earnings after the operating costs (wages, raw materials, etc.) have been taken into account, but before taxes and interest are considered. The operating profit margin typically shows how well the managers run the company since good management often translates to better company productivity.
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Return Ratios

Return ratios show how efficient a business is in generating returns in relation to the company’s assets or investor’s share or equity. This considers the different investments in the company – be it stocks, equity, or debt – and how well the company converts those investments into profit. Return ratios are divided into two categories:

  • Return on Assets (ROA): As the name implies, the return of assets represents the total amount of profit the company generates relative to its total assets (i.e., equipment). It shows the percentage of earnings the company incurs for every dollar of an asset it holds.
  • Return on Equity (ROE): The return on equity measures the percentage of earnings that the company generates in relation to its stockholder’s equity or shares. The ROE of a business is typically the one that stock markets and analysts look at when deciding whether investors should buy stocks from a specific company or not.

Cash flow Ratios

Cash flow ratios determine a company’s ability to turn its revenues into available cash. Stable cash flow is vital in businesses because it lets them keep up with business expenses, including day-to-day operating expenses and debt repayments. The higher the cash flow ratio, the more cash the company has available to pay debts, suppliers, utilities, and other expenses.

Cash flow ratios are further divided into two categories:

  • Cash Flow Margin Ratio: The cash flow margin ratio purely bases the company’s profitability on the company's cash flow movement within a specific period. The calculation of this ratio takes non-cash accounting entries, like depreciation and amortization, into account. The resulting number will then tell a business’s earnings quality.
  • Net Cash Flow: A company’s net cash flow shows the difference between the amount of money coming in and out of the company. A negative result indicates that the company is struggling to maintain a stable cash flow and may call for the need to obtain external funding, like business loans or a low-cost SBA loan. On the other hand, a positive result will mean a surplus in cash flow and a lesser likelihood of the company running out of cash.

Conclusion

A company’s revenue will vary from time to time due to seasonality. One of the ways to track your company’s performance is to measure your profitability ratio. By keeping track of the numbers, you’ll eventually identify your financial pattern and determine which area in your business you should improve upon and take appropriate action. With good profitability ratios, you will also have a chance to attract more investors to your company to further contribute to its bottom line.

About the Author

Rumzz is a digital strategist and content marketer. She enjoys writing on various parts of entrepreneurship, express her opinion and thoughts on different topics including marketing and business. She also loves playing outdoor games, traveling.

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