Profitability ratios: what they mean, types and formulae

Published Thursday 2 April 2026

Table of contents

• What do profitability ratios measure?
• Types of profitability ratios
• Profitability ratio meanings and formulae
• 1. Gross profit margin
• 2. Net profit margin
• 3. Return on assets
• 4. Return on invested capital
• Using profitability ratios in your business
• Start using Xero for free
• FAQs on profitability ratios

Key takeaways

• Calculate gross and net profit margins monthly or quarterly to track your business efficiency, as these two ratios give you the clearest picture of whether your pricing covers costs and operations run lean.
• Focus on gross profit margin first since it shows what percentage of revenue remains after direct costs, giving you the financial cushion needed to cover operating expenses like rent, utilities, and administration.
• Use return on assets and return on invested capital ratios when you're scaling up or making significant investments, as they reveal whether your equipment, property, or growth spending generates worthwhile returns.
• Compare your ratios to industry benchmarks rather than universal standards, since a healthy margin varies significantly between sectors and helps you understand where your business truly stands.

What do profitability ratios measure?

Profitability ratios measure how efficiently your business turns revenue and investments into profit. They reveal whether your pricing covers costs, your operations run lean, and your investments pay off. Banks often use this data as a standard to evaluate businesses applying for financing.

Not all ratios apply to every business. Margin ratios suit most small businesses, while return ratios become relevant when you're investing in growth.

Types of profitability ratios

Profitability ratios fall into two categories based on what they measure:

• Margin ratios: track day-to-day operating efficiency
• Return ratios: evaluate how well investments generate profit

Margin ratios

Margin ratios show what percentage of revenue remains after covering operating costs. They help you see whether your pricing and cost management are working.

The two main margin ratios are:

• Gross profit margin: measures profit after direct costs like materials or labour
• Net profit margin: measures profit after all expenses, including rent, utilities, and taxes

Return ratios

Return ratios measure how effectively your business generates profit from major investments. They're most useful when you're scaling up or evaluating whether big purchases are paying off.

The two main return ratios are:

• Return on assets (ROA): shows how well your assets generate profit
• Return on invested capital (ROIC): reveals whether new investments deliver worthwhile returns

Profitability ratio meanings and formulae

Below you'll find each profitability ratio explained in plain terms, along with the formula to calculate it and why it matters for your business.

1. Gross profit margin

Gross profit margin shows what percentage of revenue remains after paying for the products or services you sell. This is your cost of goods sold (COGS).

A healthy gross margin gives you cash to cover general expenses like rent, utilities, marketing, and administration. If it's too thin, you may struggle to stay profitable even with strong sales.

Why it matters

A higher gross margin benefits your business in two key ways:

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

• More financial cushion: you keep more revenue to cover operating costs and generate net profit
• Early warning system: tracking margins helps you spot pricing problems or rising costs before they hurt your bottom line

Once you've calculated your gross profit margin, you can take steps to improve it.

Learn more in our guide How to measure profitability. Get tips to improve these ratios in our guide How to increase profit.

2. Net profit margin

Net profit margin shows what percentage of revenue remains after paying all expenses. This is your true bottom line.

The money left over can be paid to owners as drawings or dividends, or reinvested to grow your business.

* 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.

Why it matters

A higher net profit margin means you efficiently turn sales into profit. This matters for small businesses because you don't need massive sales volume to stay profitable. While it can vary by industry, a net profit margin of 20% is considered very good, while the finance industry would consider 10% average.

Finding the right margin involves trade-offs:

• Lower prices: may increase sales volume and total profit
• Higher marketing spend: may bring in more customers
• Invest in staff: may improve service and efficiency

The goal is finding the balance that maximises profit without sacrificing growth.

• You can quote net profit before or after taxes. If quoting after-tax net profit then you need to also subtract taxes.

Once you know your net profit margin, you can identify opportunities to reduce costs or adjust pricing.

Learn more in our guide How to measure profitability. Get tips to improve these ratios in our guide How to increase profit.

3. Return on assets

Return on assets (ROA) measures how effectively your assets generate profit. Assets include property, equipment, vehicles, and intellectual property.

ROA is most useful for businesses with significant capital tied up in equipment, real estate, or other major purchases.

Why it matters

ROA helps you evaluate whether your assets are earning their keep:

• High ROA: your assets generate strong returns relative to their value
• Low ROA: you may have overinvested in equipment or property that isn't producing enough revenue

• This formula 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.

4. Return on invested capital

Return on invested capital (ROIC) measures how well new investments generate profit. It focuses specifically on money you've put into growth.

ROIC applies when you're investing in property, equipment, intellectual property, or research and development.

Why it matters

ROIC reveals whether your investments are paying off, and as a benchmark, the median return on capital across all sectors is about 12%:

• High ROIC: your growth spending generates strong returns
• Low ROIC: the investment may not be worth the cost, helping you avoid similar decisions in future

Using profitability ratios in your business

Profitability ratios help you measure how efficiently your business turns revenue and investments into profit. For most small businesses, gross and net profit margins are the most important to track regularly.

Here's how to put these ratios to work:

1. Measure your current ratios: calculate where you stand today
2. Set benchmarks: define the ratios you want to maintain
3. Set goals: identify the ratios you want to achieve over time

ROA and ROIC become relevant when you're scaling up. Even if you don't calculate them formally, the principle stands: investments need to pay for themselves and then some.

Work with your accountant or bookkeeper to identify which ratios matter most for your business. They can run the calculations and share reports easily with Xero accounting software. Track your ratios automatically with Xero's reporting features, and get one month free to see how it simplifies financial management.

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FAQs on profitability ratios

Here are answers to common questions about using profitability ratios in your small business.

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

Good ratios vary by industry. For example, a 50% gross profit margin demonstrates a healthy business in retail, while the finance industry would consider that low. Many healthy small businesses aim for a net profit margin of 10–20%. Compare your ratios to industry benchmarks to see where you stand.

How often should I calculate profitability ratios?

Calculate your ratios monthly or quarterly to spot trends early. Review them alongside your profit and loss statement so you can act on changes before they become problems.

Do I need to track all profitability ratios or can I focus on just a few?

Start with gross and net profit margins. These two ratios give you a clear picture of operating efficiency. Add ROA or ROIC later if you're making significant investments in equipment or growth.

Can I calculate profitability ratios myself or do I need an accountant?

You can calculate basic ratios yourself using figures from your profit and loss statement and balance sheet. Accounting software like Xero can automate these calculations and generate reports for you.

How does Xero help me track profitability ratios?

Xero automatically pulls the figures you need from your financial reports and can generate profitability insights in real time. You can share reports with your accountant directly from the platform.