What do profitability ratios measure?
Profitability ratios show how efficiently a business turns its spending into profits. 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
Ratios are divided into two main camps, with each focusing on a particular type of spending.
Margin ratios focus on your day to day spending (or operating expenditure). They show what percentage of revenue the business gets to keep versus the amount that goes back out the door to cover costs.
The two main margin ratios are:
- gross profit margin
- net profit margin
Return ratios focus on big-ticket investments. They’re more relevant to businesses that are in growth mode as they help measure the return on expensive growth initiatives.
The two main return ratios are:
- return on assets (ROA)
- return on invested capital (ROIC)
Profitability ratio meanings and formulae
1. Gross profit margin
The gross profit margin shows what percentage of revenue is left after paying for the things you sell (costs of goods (or services) sold). Your gross margin needs to be a decent size because you will use the resulting cash to pay general expenses like rent, utilities, marketing, insurance, administration and more.
Why it matters
A higher gross margin means you hold onto a bigger chunk of sales revenue, which gives you more runway to pay general costs and still bank a net profit. Monitoring your margins helps you spot threats to your sustainability, or opportunities to improve performance.
Formula for calculating gross profit margin ratio
2. Net profit margin
The net profit margin shows what percentage of revenue is left after paying all expenses. It’s the portion of sales that you get to keep in the business. That money can be paid to owners or reinvested in growth.
Why it matters
A higher net profit margin means you’re efficient at turning sales into profits. Higher net margins make you less reliant on big sales figures, which can be handy for small businesses that don’t have the size to work at scale.
There’s a sweet spot when it comes to margins. By lowering prices, you might increase sales and ultimately drive profits higher. Or you could keep prices the same but spend more of that revenue on marketing to bring extra business in the door. Or you could spend it on employees that make business easier. It’s a delicate balance.
Formula for calculating net profit margin ratio
* Net profit can be quoted before or after taxes. If quoting after-tax net profit then you need to also subtract taxes.
3. Return on assets
Return on assets (ROA) shows how you make money from your assets, such as property, work tools and so on. This one can get technical and is probably only relevant if you have lots invested in expensive equipment, real estate or intellectual property.
Why it matters
ROA is a way of testing the wisdom and efficiency of your investments. 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
* 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.
4. Return on invested capital
Return on invested capital (ROIC) shows how you make money from new investments. This is also technical and is really only relevant if you’re spending lots on things like property, buildings, equipment, IP or research and development.
Why it matters
ROIC will reveal if you wasted money on unnecessary assets or projects so that you can avoid similar mistakes in the future.
Formula for calculating return on invested capital ratio
Using profitability ratios in your business
Profitability ratios allow small businesses to measure how efficiently they turn costs and investments into profit. It’s especially helpful to track your gross and net profit margins as they’re key to your operating sustainability. Measure them so you know what your profitability ratios are. Use that to set benchmarks (ratios that you’d like to maintain) and goals (ratios you’d like to achieve).
ROA and ROIC may become relevant as you consider scaling up your business. But even if you don’t formally measure them, it’s a good idea to keep the principles in mind. Investments need to pay for themselves and then some.
Work with your accountants or bookkeepers to determine which types of profitability ratios are most relevant to your business. They can also run the calculations for you and can easily share reports with software like Xero.
Xero does not provide accounting, tax, business or legal advice. This guide has been provided for information purposes only. You should consult your own professional advisors for advice directly relating to your business or before taking action in relation to any of the content provided.
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