Profitability ratios: types, formulas and business uses

Published Wednesday 22 April 2026

Table of contents

• What do profitability ratios measure?
• What can profitability ratios tell you?
• Types of profitability ratios
• Gross profit margin
• Net profit margin
• Return on assets
• Return on invested capital
• Using profitability ratios in your business
• FAQs on profitability ratios

Key takeaways

• Start by tracking gross profit margin and net profit margin regularly, as these two ratios give you the clearest picture of whether your business is covering its costs and turning sales into real profit.
• Compare your ratios against industry benchmarks, such as those published by the ATO, to spot gaps early and identify where your pricing or expenses may need adjusting.
• Account for every cost, no matter how small, because even unrecorded expenses like freight or handling charges can quietly eat into your margins without you noticing.
• Add return on assets and return on invested capital to your tracking as your business grows, so you can check whether major purchases and investments are actually paying off.

What do profitability ratios measure?

Profitability ratios are financial metrics that measure how efficiently your business converts what it spends into profits. They focus on different types of expenses to reveal your business performance.

Not all ratios will be relevant to every small business, as official benchmarks account for businesses across 100 industries with varying turnover ranges. The key is identifying which ones matter most for your situation.

What can profitability ratios tell you?

Profitability ratios reveal your business's financial health by answering key performance questions. They turn financial data into simple insights so you can make confident decisions.

These ratios help you identify:

• Pricing accuracy: whether your prices generate enough margin
• Cost efficiency: where expenses may be too high
• Investment returns: how well your spending pays off

For instance, one study analysed a company and found its salary expense was 53.2% of sales, more than double the industry benchmark. This kind of insight helps you spot problems early and plan for growth.

Types of profitability ratios

Profitability ratios fall into two main categories: margin ratios and return ratios. Each measures different aspects of your business spending.

Margin ratios

Margin ratios measure your day-to-day operational spending and show what percentage of revenue you keep after covering costs.

The two essential margin ratios are gross profit margin and net profit margin. Gross profit margin shows profit after direct costs of goods or services sold. Net profit margin shows profit after all business expenses.

Return ratios

Return ratios measure how effectively your business generates profit from major investments and assets. These ratios are most relevant for growing businesses with significant equipment, property, or development costs.

The two key return ratios are return on assets (ROA), which measures profit generated from all business assets, and return on invested capital (ROIC), which measures profit from new investments and projects.

Gross profit margin

Gross profit margin shows what percentage of revenue remains after paying for the direct costs of your products or services.

This margin must be high enough to cover general business expenses like rent, utilities, marketing, insurance, and administration.

Even small, unrecorded costs can significantly affect your margins. One case study showed that unaccounted freight and potting charges caused most of a business's gross margin to decrease.

Formula for calculating gross profit margin ratio

See How to measure profitability and How to increase profit for more details.

Net profit margin

Net profit margin shows what percentage of revenue remains after paying all business expenses, a metric the Australian Taxation Office (ATO) calculates for industry benchmarks using data from tax returns. This is your true profit: the portion of sales you actually keep.

Comparing this to industry standards is key. One business discovered its net profit margin was -29.39%, revealing a 43% gap from the industry benchmark of 13.76% and a clear opportunity for improvement.

Why it matters

• Improves efficiency: shows you're effective at converting sales to profit
• Reduces volume dependence: lessens reliance on high sales figures to stay profitable
• Creates strategic flexibility: gives you more options for business decisions

Finding your profit sweet spot involves balancing three strategies. You can lower prices to increase sales volume and boost total profits. You can maintain prices and invest more in marketing to attract new customers. Or you can reinvest profits to hire staff or improve systems to make operations easier.

Formula for calculating net profit margin ratio

• Net profit can be quoted before or after taxes. If quoting after-tax net profit, also subtract taxes.

See How to measure profitability and How to increase profit for more details.

Return on assets

Return on assets (ROA) measures how effectively your business generates profit from its assets, including property, equipment, and tools.

This ratio is most relevant if your business has significant investments in expensive equipment such as manufacturing tools, vehicles, or machinery; real estate such as owned property or facilities; or intellectual property such as patents, software, or proprietary systems.

Why it matters

ROA tests how wisely and efficiently you've invested. A high ratio suggests you're getting good value out of your assets, while a low ratio may indicate you've overinvested in certain areas.

Formula for calculating return on assets ratio

• This formula uses value of assets rather than 'average value of assets' because the latter applies to businesses that buy and sell assets frequently, which doesn't reflect most small businesses.

Use this formula to work out your return on assets:

Return on Assets = Net Profit ÷ Total Assets

Return on invested capital

Return on invested capital (ROIC) measures how effectively your business generates profit from new investments and major expenditures.

This ratio is most valuable when you're investing heavily in property and buildings such as new facilities or major renovations; equipment upgrades such as manufacturing systems or technology; intellectual property such as software development or patent creation; or research and development for new product or service innovation.

Why it matters

ROIC reveals if you wasted money on unnecessary assets or projects so you can avoid similar mistakes.

Formula for calculating return on invested capital ratio

Using profitability ratios in your business

Using profitability ratios helps you track performance, set targets, and decide with confidence. Start with essential ratios for immediate business insights.

Track gross and net profit margins, as these are crucial for operating sustainability. Measure regularly to know your current ratios and establish baselines. Set benchmarks by defining ratios you want to maintain, comparing to official industry data such as the ATO benchmarks for businesses with turnover up to $15 million, which exclude businesses earning less than $10,000 to prevent skewing the averages. Create goals by identifying target ratios for improvement.

Consider advanced ratios as your business grows. Track ROA and ROIC when scaling operations. Adopt an investment mindset: investments must generate returns, even without formal tracking.

Get professional support to analyse your ratios accurately:

• Work with your accountant or bookkeeper to calculate ratios correctly
• Compare your results to industry benchmarks
• Review ratios regularly to track progress and adjust strategies

FAQs on profitability ratios

Here are answers to common questions about profitability ratios.

What is a good profit margin for a small business?

A good profit margin varies by industry. Check the ATO benchmarks for your specific industry to see how your margins compare.

How often should I calculate profitability ratios?

Calculate your profitability ratios monthly or quarterly to track trends and identify issues early.

Which profitability ratio is most important?

Gross profit margin and net profit margin are the most important for most small businesses. They show your operating sustainability and overall profitability.

What if my profitability ratios are lower than industry benchmarks?

Review your costs and pricing to identify opportunities for improvement. Your accountant can help you analyse the gaps and create an action plan.