Profitability ratios: what they are, types and uses

Published Saturday 7 March 2026

Table of contents

• What do profitability ratios measure?
• Types of profitability ratios
• Gross profit margin
• Net profit margin
• Operating profit margin
• Return on assets (ROA)
• Return on equity (ROE)
• Return on invested capital (ROIC)
• Which profitability ratios matter most for small businesses?
• How to use profitability ratios in your business
• FAQs on profitability ratios

Key takeaways

• Focus on gross profit margin and net profit margin first, as these show whether your pricing covers direct costs and your overall bottom-line profitability after all expenses.
• Calculate your profitability ratios monthly or quarterly to spot trends early and make timely adjustments to pricing, costs, or business operations.
• Use return ratios like ROA and ROIC only when you've made significant investments in equipment, property, or other major assets to evaluate whether those investments are generating adequate returns.
• Set benchmarks by comparing your ratios to industry standards and your own historical performance, then establish specific targets for improvement rather than tracking ratios without context.

What do profitability ratios measure?

Profitability ratios are financial metrics that measure how well your business generates profit relative to revenue, costs, or investments. This is a key part of assessing your ability to continue as a going concern.

They show how efficiently you turn spending into earnings. Different types of ratios focus on different types of spending, and not all of them will be relevant to every small business.

Types of profitability ratios

Profitability ratios fall into two main categories: margin ratios and return ratios. Each focuses on a different type of spending.

Margin ratios

Margin ratios measure what percentage of revenue your business keeps after covering costs. They focus on day-to-day operating expenses.

The main margin ratios are:

• Gross profit margin: measures profit after direct costs of goods or services
• Net profit margin: measures profit after all expenses
• Operating profit margin: measures profit from core business operations

Return ratios

Return ratios measure how effectively your business generates profit from investments and assets. They're most relevant if you're in growth mode or evaluating expensive initiatives.

The main return ratios are:

• Return on assets (ROA): measures profit generated from total assets
• Return on equity (ROE): measures profit generated for shareholders
• Return on invested capital (ROIC): measures profit generated from capital investments

Gross profit margin

Gross profit margin shows what percentage of revenue remains after paying for the direct costs of goods or services sold. This is the money available to cover your operating expenses.

Your gross margin needs to be large enough to pay for:

• rent and utilities
• marketing and advertising
• insurance and administration
• other overhead costs

Why it matters

A higher gross margin means you keep more of each sale. This gives you more room to cover operating costs and still generate net profit.

Monitoring your margins helps you spot threats early and identify opportunities to improve performance.

* Net profit can be quoted before or after taxes. If quoting after-tax net profit then you need to also subtract taxes.

Learn more in our guide How to measure profitability.

Get tips to improve these ratios in our guide How to increase profit.

Net profit margin

Net profit margin shows what percentage of revenue remains after paying all expenses, including operating costs, interest, and taxes. This is the profit you can pay to owners or reinvest in your business.

Why it matters

A higher net profit margin means you're efficient at turning sales into profits. This makes you less reliant on high sales volume, which can be helpful for small businesses that don't operate at scale.

Finding the right margin involves trade-offs:

* We use value of assets rather than 'average value of assets' because the latter is for businesses that are buying and selling assets all the time... which doesn't reflect a small business.

• Lower prices: may increase sales volume and drive higher total profits
• Invest in marketing: may bring in more customers while maintaining prices
• Hire staff: may improve operations and customer experience

It's a delicate balance between margin and growth.

* Net profit can be quoted before or after taxes. If quoting after-tax net profit then you need to also subtract taxes.

Learn more in our guide How to measure profitability.

Get tips to improve these ratios in our guide How to increase profit.

Operating profit margin

Operating profit margin shows what percentage of revenue remains after paying both direct costs and operating expenses, but before interest and taxes. It measures how profitable your core business operations are.

This ratio sits between gross and net profit margin. It excludes financing costs and taxes, so it gives you a clearer picture of operational efficiency.

Why it matters

Operating margin reveals how well you manage day-to-day costs. A healthy operating margin means your pricing and cost control are working together effectively.

Use it to:

• compare performance across different periods
• benchmark against competitors in your industry
• identify whether operational costs are eating into profits

Formula for calculating operating profit margin ratio

Operating profit margin = (Operating profit ÷ Revenue) × 100

Where operating profit = Revenue − Cost of goods sold − Operating expenses

Return on assets (ROA)

Return on assets (ROA) measures how efficiently your business generates profit from its total assets. Assets include property, equipment, vehicles, and intellectual property.

This ratio is most relevant if you've invested significantly in expensive equipment, real estate, or other major assets.

Why it matters

ROA helps you evaluate whether your asset investments are paying off:

• High ROA: indicates you're generating strong returns from your assets
• Low ROA: may suggest you've overinvested or your assets aren't being used efficiently

* This uses value of assets rather than 'average value of assets' because the latter is for businesses that are buying and selling assets all the time, which doesn't reflect a small business.

Return on equity (ROE)

Return on equity (ROE) measures how effectively your business generates profit from shareholders' equity. It shows the return owners or investors receive on their investment in the business.

Why it matters

ROE is particularly useful if you have investors or are considering bringing them on. A strong ROE signals that you're using shareholder funds efficiently to generate profits. For example, Canadian banks have reported the highest return on equity on average in recent years compared to global peers.

It's also helpful for:

• comparing your performance to similar businesses
• demonstrating value to potential investors
• evaluating whether to reinvest profits or distribute them

Formula for calculating return on equity ratio

Return on equity = (Net profit ÷ Shareholders' equity) × 100

Where shareholders' equity = Total assets − Total liabilities

Return on invested capital (ROIC)

Return on invested capital (ROIC) measures how effectively your business generates profit from capital you've invested. This includes money spent on:

• property and buildings
• equipment and machinery
• intellectual property
• research and development

ROIC is most useful for businesses making significant capital investments.

Why it matters

ROIC reveals whether your capital investments are generating adequate returns. Use it to identify underperforming investments and make smarter decisions about future projects.

Which profitability ratios matter most for small businesses?

Not every ratio is equally important for every business. Here's how to prioritize based on your situation.

For most small businesses, start with:

• Gross profit margin: shows whether your pricing covers direct costs
• Net profit margin: shows your bottom-line profitability after all expenses

Add operating profit margin if:

• you want to isolate operational efficiency from financing decisions
• you're comparing performance across different time periods
• you're benchmarking against industry competitors

Track return ratios when:

• you've made significant investments in equipment, property, or other assets
• you have investors or shareholders
• you're evaluating major capital expenditure decisions

Most small businesses should focus on margin ratios first. Return ratios become more relevant as you grow and make larger investments.

How to use profitability ratios in your business

Once you understand the different types of profitability ratios, you can start applying them to your business decisions. Here's how to put them to work:

Start with margin ratios: Track your gross and net profit margins regularly. These are essential for understanding your operating sustainability.

Set benchmarks and goals: Use your current ratios as a baseline, then set targets for where you want to be.

Add return ratios as you grow: ROA and ROIC become more relevant when you're making significant investments in assets or expansion.

Work with your advisor: Your accountant or bookkeeper can help you identify which ratios matter most for your business. They can run the calculations and share reports through software like Xero.

Ready to track your profitability more easily? Get one month free.

FAQs on profitability ratios

Here are answers to common questions about profitability ratios.

What's a good profitability ratio for a small business?

It varies by industry, but a net profit margin of 10% or higher is generally considered healthy for most small businesses. Compare your ratios to industry benchmarks to understand where you stand.

Which profitability ratio is most important for small businesses?

Net profit margin is typically the most important because it shows your actual bottom-line profit after all expenses. However, tracking gross profit margin alongside it gives you a more complete picture.

How often should I calculate profitability ratios?

Calculate your profitability ratios monthly or quarterly to spot trends early. This aligns with standard business practices. Public companies often prepare quarterly financial statements to monitor performance. Review them whenever you make pricing changes, take on new costs, or evaluate business performance.

Can profitability ratios help me get a business loan?

Yes. Lenders use profitability ratios to assess whether your business generates enough profit to repay a loan. Strong margins demonstrate financial health and reduce lending risk. Lenders analyze various factors to determine this risk. Data on Canadian banking shows that retail and mortgage risk weights are near the lower end of their peer group.

How can accounting software help me track profitability ratios?

Accounting software like Xero automatically calculates key metrics from your financial data. You can view profitability reports in real time without manual calculations, making it easier to monitor trends and share insights with your accountant.