Profitability ratios: types, formulas and what to track

Published Thursday 2 April 2026

Table of contents

• What are profitability ratios?
• What do profitability ratios measure?
• Types of profitability ratios
• 1. Gross profit margin
• 2. Net profit margin
• 3. Operating profit margin
• 4. Return on assets
• 5. Return on equity
• 6. Return on invested capital
• Using profitability ratios in your business
• FAQs on profitability ratios

Key takeaways

• Start tracking gross profit margin and net profit margin first, as these essential ratios show whether your business keeps enough money from each sale to cover operating costs and generate sustainable profit.
• Calculate your profitability ratios monthly or quarterly to spot trends early and take action before small issues become big problems that hurt your bottom line.
• Focus on net profit margin as your most important ratio since it reveals your true bottom-line profit after all expenses, with most small businesses aiming for 10-20% net profit margin.
• Add return ratios like return on assets and return on equity later as your business grows and makes larger investments, since these become more relevant when evaluating expensive purchases or expansion projects.

What are profitability ratios?

Profitability ratios are financial metrics that measure how well your business generates profit relative to revenue, assets, or equity. They help you see whether your business is making money efficiently, not just bringing in sales.

These ratios fall into two main categories: margin ratios (which focus on profit from sales) and return ratios (which focus on profit from investments). Small businesses typically track margin ratios first, then add return ratios as they grow.

What do profitability ratios measure?

Profitability ratios measure how efficiently your business converts spending into profit. They reveal whether you're keeping enough of each dollar earned after covering costs.

Different ratios focus on different types of spending:

• Margin ratios: measure profit relative to revenue (day-to-day operating costs)
• Return ratios: measure profit relative to assets or investments (big-ticket purchases)

Not every ratio applies to every business. Start with the ones that match your current priorities.

Types of profitability ratios

Profitability ratios fall into two categories based on what they measure. Understanding the difference helps you choose which ratios to track.

Margin ratios

Margin ratios measure what percentage of revenue remains after covering costs. They focus on day-to-day operating expenses and show how much of each sale you keep as profit.

The three main margin ratios are:

• gross profit margin: profit after direct costs of goods or services
• net profit margin: profit after all expenses
• operating profit margin: profit from core business operations

Return ratios

Return ratios measure how well your business generates profit from investments. They're most useful when you're in growth mode or evaluating big-ticket purchases like equipment, property, or expansion projects.

The three main return ratios are:

• return on assets (ROA): profit generated from total assets
• return on equity (ROE): profit generated for owners or shareholders
• return on invested capital (ROIC): profit generated from specific investments

1. Gross profit margin

Gross profit margin shows what percentage of revenue remains after paying for the direct costs of goods or services sold. It's the first layer of profit before covering general business expenses.

A healthy gross margin gives you enough cash to pay for rent, utilities, marketing, insurance, and administration. If your gross margin is too thin, you may struggle to cover these costs and still turn a profit.

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

Why it matters

A higher gross margin means more cash stays in your business after each sale. Here's why tracking it helps:

• Pricing decisions: Reveals whether your prices cover production costs.
• Sustainability check: Spots threats before they hurt your bottom line.
• Performance opportunities: Highlights areas to cut costs or boost efficiency.

Formula for calculating gross profit margin ratio

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

Learn more about measuring and improving profitability in our guides on how to measure profitability and how to increase profit.

* 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.

2. Net profit margin

Net profit margin shows what percentage of revenue remains after paying all expenses. It's your true bottom-line profit.

This is the money you get to keep. You can pay it to owners, reinvest it in growth, or hold it as a cash reserve.

Why it matters

A higher net profit margin means you're efficient at turning sales into actual profit. Here's why it's important:

• Less volume pressure: You don't need massive sales to stay profitable.
• Growth flexibility: More profit means more options for reinvestment.
• Business sustainability: Healthy margins protect you during slow periods.

Finding the right margin involves trade-offs. Lowering prices might boost sales volume. Spending more on marketing might bring in new customers. The key is tracking your net margin so you can see how these decisions affect your bottom line.

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

Formula for calculating net profit margin ratio

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

Learn more about measuring and improving profitability in our guides on how to measure profitability and how to increase profit.

3. Operating profit margin

Operating profit margin shows what percentage of revenue remains after covering operating expenses but before interest and taxes. It measures how efficiently your core business generates profit.

This ratio strips out financing costs and tax effects for a clearer view of operational performance, and a new IFRS accounting standard effective from 1 January 2027 will help standardise this calculation across businesses. It's useful for comparing your efficiency against competitors or tracking improvements over time.

Why it matters

Operating profit margin reveals whether your business model works before external factors like debt or tax rates come into play. Here's why it's valuable:

• Operational efficiency: Shows how well you control day-to-day costs.
• Benchmarking: Lets you compare performance against similar businesses, though this can be difficult as one study found companies calculating operating profit in at least nine different ways.
• Decision-making: Helps you identify where to cut costs or invest.

Formula for calculating operating profit margin

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

Where operating profit = Revenue minus operating expenses (excluding interest and taxes)

4. Return on assets

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

ROA is most useful if you've invested significantly in physical assets or are comparing your efficiency against competitors with similar asset bases.

Why it matters

ROA helps you evaluate whether your assets are earning their keep. Here's what it reveals:

• Investment efficiency: Shows if expensive purchases are generating enough profit.
• Overinvestment warning: A low ratio may signal you've bought more than you need.
• Comparison tool: Lets you benchmark against businesses with similar asset levels.

* 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.

Formula for calculating return on assets ratio

Return on assets = (Net profit ÷ Total assets) × 100

5. Return on equity

Return on equity (ROE) measures how efficiently your business generates profit from shareholders' or owners' equity. It shows the return on the money owners have invested in the business.

ROE is particularly useful if you have business partners, outside investors, or are considering bringing on new shareholders. It answers the question: "How much profit is the business generating for each dollar of ownership?"

Why it matters

ROE helps owners and investors evaluate whether their money is working hard enough. Here's why it's important:

• Owner returns: Shows how much profit owners earn on their investment.
• Investor appeal: A strong ROE attracts potential investors or partners.
• Growth decisions: Helps you decide whether to reinvest profits or distribute them.

Formula for calculating return on equity

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

Where shareholders' equity = Total assets minus total liabilities

6. Return on invested capital

Return on invested capital (ROIC) measures how efficiently your business generates profit from specific capital investments. It evaluates whether money spent on property, equipment, research, or expansion is paying off.

ROIC is most relevant when you're making significant investments in growth and want to track whether those decisions are generating adequate returns.

Why it matters

ROIC helps you evaluate whether capital investments are generating enough return. Here's what it reveals:

• Investment performance: Shows which projects or purchases are paying off.
• Future decisions: Guides where to invest (or not invest) next.
• Capital efficiency: Compares returns across different investment options.

Formula for calculating return on invested capital ratio

Return on invested capital = (Net operating profit after tax ÷ Invested capital) × 100

Using profitability ratios in your business

Profitability ratios help you measure how efficiently your business turns costs and investments into profit. Tracking them regularly lets you spot problems early and make better decisions.

Here's how to put these ratios to work:

• Start with margins: Track gross and net profit margins first as they're essential for operating sustainability.
• Set benchmarks: Establish target ratios you want to maintain.
• Define goals: Identify the ratios you want to achieve as you grow.
• Add return ratios later: Return on assets (ROA), return on equity (ROE), and return on invested capital (ROIC) become more relevant as you scale and make larger investments.

Work with your accountant or bookkeeper to determine which ratios matter most for your business. They can run calculations and share reports through accounting software like Xero.

Tracking profitability ratios is easier with the right tools. With Xero's accounting software, you can generate reports and calculate key metrics to monitor your margins and returns without manual spreadsheets. Get one month free and see how Xero simplifies financial tracking for your business.

FAQs on profitability ratios

Here are answers to common questions about profitability ratios.

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

Good ratios vary by industry, but most small businesses aim for a gross profit margin of 50% or higher and a net profit margin of 10–20%. Compare your ratios to industry benchmarks to see where you stand.

Which profitability ratio is most important?

For most small businesses, net profit margin is the most important ratio because it shows your true bottom-line profit after all expenses. Start there, then add other ratios as your business grows.

How often should I calculate profitability ratios?

Calculate your profitability ratios monthly or quarterly to spot trends early. Review them alongside your financial statements so you can take action before small issues become big problems.

Can accounting software calculate these ratios for me?

Yes. Most accounting software, including Xero, can generate profit and loss reports that make calculating profitability ratios straightforward. Some platforms also include built-in ratio calculations and dashboards.