The 10 Most Important Profitability Ratios Every Business Needs To Understand
Profitability ratios are key indicators of a company’s financial health and performance. They provide insights into a company’s margin, return on investment (ROI), and ability to generate cash flow.
Various profitability ratios can be used to assess a company’s financial health. However, not all of them are equally important. Some ratios are more relevant to certain industries than others.
In this article, we will discuss the 10 most important profitability ratios that every business needs to understand. These ratios will give you a good understanding of a company’s overall financial health and performance.
Gross Margin Ratio
The gross margin ratio is a profitability ratio that measures the percentage of revenue that a company retains after accounting for the cost of goods sold (COGS). This ratio reveals the margin that a company makes on each dollar of sales. A higher gross margin ratio indicates that a company can generate more revenue on each dollar of sales.
The gross margin ratio is calculated by dividing gross profit by revenue. Gross margin = (Revenue - COGS) / Revenue For example, if a company has a gross profit of $1,000 and revenue of $5,000, its gross margin ratio would be 20%.
Gross margin ratios can vary depending on the industry. For example, companies in the food and beverage industry typically have a lower gross margin than companies in the information technology industry.
Investors and analysts use the gross margin ratio to assess a company’s profitability and compare it to other companies in the same industry.
A company with a high gross margin ratio reflects a higher efficiency of operations, meaning it can still cover operating expenses, fixed costs, dividends, and depreciation, while also providing net earnings to the business.
EBITDA Margin
The EBITDA margin is a profitability ratio that measures the percentage of a company’s revenue that is left over after accounting for expenses.
EBITDA stands for earnings before interest, taxes, depreciation, and amortization. The EBITDA margin is calculated by dividing EBITDA by revenue.
EBITDA margin = EBITDA / Revenue For example, if a company has an EBITDA of $1,000 and revenue of $10,000, its EBITDA margin would be 10%.
The EBITDA margin is a good measure of a company’s operating efficiency and profitability. It is a popular metric among investors and analysts because it strips out non-operating expenses such as interest, taxes, depreciation, and amortization.
A company with a higher EBITDA margin is more profitable than a company with a lower EBITDA margin.
Net Profit Margin Ratio
The net profit margin ratio is a profitability ratio that measures the percentage of revenue that a company retains after accounting for all expenses. This ratio reveals the margin that a company makes on each dollar of sales after accounting for all costs.
The net profit margin ratio is calculated by dividing net profit by revenue. Net profit margin = Net Profit / Revenue For example if a company has a net profit of $1,000 and revenue of $20,000, its net profit margin would be 5%.
The net profit margin ratio is considered to be the most accurate measure of a company’s profitability. It is a popular metric among investors and analysts because it gives insights into a company’s overall profitability.
A company with a higher net profit margin is more profitable than a company with a lower net profit margin.
A downside of this ratio is that it includes single expenditures and also gains, which makes it harder to contrast a firm’s efficiency with its competitors.
Operating Profit Margin
The operating profit margin is a profitability ratio that measures the percentage of a company’s revenue that is left over after accounting for operating expenses. Operating expenses are the costs that are incurred from running the day-to-day operations of a business. They include things like salary, rent, utilities, and other similar expenses.
The operating profit margin is calculated by dividing operating profit by revenue. Operating profit margin = Operating profit / Revenue For example, if a company has an operating profit of $1,000 and revenue of $5,000, its operating profit margin would be 20%.
The operating profit margin is a good measure of a company’s operating efficiency and profitability.
Companies with high operating profit margins are usually more well-equipped to spend for taken care of prices and interest on responsibilities, have far better opportunities to make it through a financial stagnation, and also are a lot more with the ability to offer reduced costs than their competitors that have a reduced profit margin.
Operating profit margin is regularly made use of to evaluate the strength of a business’s administration considering that good management can significantly improve the earnings of a company by managing its operating expense.
Cash Flow Margin
Cash flow margin - shares the connection between cash flows from operating activities and also sales produced by the company. It gauges the capacity of the firm to transform sales right into cash.
The higher the percentage of cash flow, the more money readily available from sales to pay for vendors, dividends, utilities, and also service financial debt, as well as to purchase capital possessions. Negative cash flow, however, means that even if the business is creating sales or profits, it may still be losing money. In the instance of a business with inadequate capital, the firm might opt to obtain funds or raise money through investors to maintain operations going.
The cash flow margin is calculated by dividing operating cash flow by revenue. Operating cash flow = Net Income + Depreciation & Amortization – Change in Working Capital Cash flow margin = Operating cash flow / Revenue For example, if a company has an operating cash flow of $1,000 and revenue of $5,000, its cash flow margin would be 20%.
Managing cash flow is crucial to a business’s success because constantly having appropriate cash flow both lessens expenses (e.g., staying clear of late settlement charges and also added interest cost) as well as makes it possible for a company to make the most of any type of additional revenue or growth possibilities that may arise (e.g. the opportunity to buy at a significant discount the stock of a competitor that goes out of business).
Return on Invested Capital(ROIC)
The return on invested capital (ROIC) is a profitability ratio that measures the percentage of a company’s profits that are generated from its invested capital. Invested capital includes things like debt, equity, and other forms of long-term funding.
The ROIC is calculated by dividing net income by invested capital. ROIC = Net Income / Invested Capital For example, if a company has a net income of $1,000 and invested capital of $5,000, its ROIC would be 20%.
The ROIC is a good measure of a company’s ability to generate profits from its invested capital.
It tells us how well a company is using its capital to generate profits. A company with a higher ROIC is more profitable than a company with a lower ROIC.
Return on Assets (ROA)
The return on assets (ROA) is a profitability ratio that measures the percentage of a company’s profits that are generated from its assets. Assets include things like cash, inventory, and property.
The ROA is calculated by dividing net income by total assets. ROA = Net Income / Total Assets For example, if a company has a net income of $1,000 and total assets of $5,000, its ROA would be 20%.
The ROA is a good measure of a company’s overall profitability. it shows how well a company is using its assets to generate profits. A company with a higher ROA is more profitable than a company with a lower ROA.
Return on Equity (ROE)
Return on equity (ROE) is the measure of a company’s net income divided by its shareholders’ equity. ROE is a gauge of a corporation’s profitability and how efficiently it generates those profits. The higher the ROE, the better a company is at converting its equity financing into profits.
Since ROE includes both profitability and leverage, it is considered to be a more comprehensive measure of a company’s overall performance than either ROA or financial leverage alone.
ROE is used when comparing the financial performance of companies within the same industry. It is a measure of the ability of management to generate income from the equity available to it. A return of between 15-20% is considered good. ROE is also used when evaluating stocks, as well as other financial ratios.
Debt-to-Equity Ratio
The debt-to-equity ratio measures your company’s total debt relative to the amount originally invested by the owners and the earnings that have been retained over time.
In general, a lower D/E ratio is preferred as it indicates less debt on a company’s balance sheet.
If your debt ratio does not exceed 30%, the banks will find it excellent. Your ratio shows that if you manage your daily expenses well, you should be able to pay off your debts without worry or penalty. A debt ratio between 30% and 36% is also considered good.
Current Ratio
The current ratio is a liquidity ratio that measures a company’s ability to pay short-term obligations or those due within one year. It tells investors and analysts how a company can maximize the current assets on its balance sheet to satisfy its current debt and other payables.
Current Ratio = Current Assets / Current Liabilities
This includes accounts payable, payroll, credit cards, and sales tax payable, among other items. In dividing total current assets by total current liabilities, you’ll find out how much of your current liabilities can be covered by current assets.
The current ratio is considered by creditors while evaluating a company’s credit status before offering short-term debts. This ratio also gives insight into a company’s operating cycle. It reflects a company’s ability to liquidate its assets for paying off its short-term liabilities.
To develop other critical measures for your business tap into Bernie Smith’s CFO Talk, The CFOs Guide to Great KPIs.
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