Profitability
Profitability shows how efficiently your business turns sales into profit. See how to measure it.
June 2023 | Published by Xero
Published Thursday 23 July 2026
Table of contents
Key takeaways
- Profitability measures how efficiently your business turns expenses into profit, while profit is simply the money you bank.
- Profit margin is the most common way to gauge profitability, showing what portion of each sale you keep after costs.
- You can measure profitability with gross, net and operating profit margins, plus return ratios like return on assets and return on equity.
- Profitability and cash flow are not the same: a profitable business can still run short of cash if money comes in slower than it goes out.
Profitability (definition)
Profitability is a measure of how efficiently a business converts its expenses into profits for its owners.
Profit margin is perhaps the most common profitability measure. It shows what portion of each sale goes toward meeting your costs, and what portion you keep.
Profit vs profitability
Profit is the amount of income your business banks. Profitability is the portion of income your business banks, so it tells you how hard each sale is working for you.
Two businesses can bank very different amounts and still tell you very different stories. Here's how the two can pull apart:
- Big profits with low profitability: your business banks $1 million in profit, but you had to make $7 million in sales to earn it
- High profitability with small profits: your business keeps 50% of each sale as profit, but only made $10,000 worth of sales
Most businesses try to strike a balance between profit and profitability, usually through the way they price their products and services.
How to measure profitability
You measure profitability with ratios that compare what you keep against what you make. The three margins below are the ones most small businesses rely on, and each one looks at a different layer of your costs.
Gross profit margin
Gross profit margin is the first layer, showing what's left once you cover the direct costs of delivering your product or service. This ratio shows what portion of sales income remains after meeting the costs of delivering services, creating products, or buying stock. You can dig deeper in our guide to gross profit margin.
Net profit margin
Net profit margin goes a step further and factors in every cost your business carries. This ratio shows what portion of sales income is left after meeting all business costs, including production plus other operating expenses like rent, marketing, insurance and interest on loans. See how it stacks up against other measures in our glossary entry on net profit margin.
Operating profit margin
Operating profit margin sits between the gross and net figures, focusing on how well your core operations perform. It shows what portion of sales income is left after covering operating costs, but before interest and tax, so you can see how profitable the business is day to day. It's a useful check on whether your everyday running costs are eating into your returns.
Beyond margins, return ratios show how well you turn resources into profit. Return on assets measures the profit you generate from everything your business owns, while return on equity measures the profit you generate from the money owners have put in. Both sit alongside margins in the wider family of profitability ratios.
How to calculate profitability
The two margins most small businesses calculate are gross profit margin and net profit margin. Both pull their figures from your profit and loss statement, so the numbers are already in front of you.
Gross profit margin formula
Gross profit margin tells you what percentage of your sales income is gross profit. The formula is straightforward once you have the two figures it needs.
Gross profit margin = (gross profit / revenue) x 100, where gross profit = revenue minus the cost of goods sold (also known as direct costs). You can brush up on how revenue and cost of goods sold work together if you need a refresher.
Net profit margin formula
Net profit margin tells you what percentage of your sales income is net profit. It uses the same shape of formula, but with a broader set of costs subtracted.
Net profit margin = (net profit / revenue) x 100, where net profit = revenue minus all business expenses (both direct and indirect costs). If you sometimes see EBITDA (earnings before interest, taxes, depreciation and amortisation), that's another profitability measure used more often by larger corporations than small businesses.
Profitability vs cash flow
Profitability and cash flow are easy to confuse, but they answer different questions. Profitability, drawn from your income statement, tells you whether your business earns more than it spends over a period; cash flow tells you whether you have money available right now.
A profitable business can still hit cash flow gaps. If customers pay slowly while bills fall due, you can be profitable on paper and short of cash in the bank, so it pays to watch both.
Why profitability matters
Profitability is a direct read on how efficient your business is. The more profit you capture from each sale, or from each hour worked, the more efficient you are.
Higher profitability means an increase in business activity can boost profits significantly. It also gives you options: you can grow faster, or generate good income while working less if you're chasing better work-life balance.
There's a limit worth watching, though. Businesses with very high margins can become too expensive for their customers, which slows sales and can end up reducing revenue and profits.
Common ways to increase profitability
Small changes to pricing, costs and processes can lift your margins over time. Here are practical ways to increase profitability:
- Increase prices or adjust your fee structures
- Offer fewer price promotions
- Set standards around marketing return on investment
- Find cheaper suppliers or buy supplies in bulk
- Develop more efficient workflows
- Track projects against budgets
- Automate repetitive processes to reduce costs
Track your profitability with Xero
Keeping an eye on your margins is far easier when your numbers live in one place. Xero pulls your income and expenses together and turns them into simple reports, so you can see where your margins stand and get one month free.
FAQs on profitability
Here are answers to some frequently asked questions about profitability for small business owners.
What is the difference between profit and profitability?
Profit is the total money your business banks, while profitability is the portion of income you keep relative to what you make. Profitability tells you how efficiently each sale generates profit, not just the final dollar figure.
How is profitability measured?
Profitability is most often measured with profit margins: gross, operating and net. Return ratios like return on assets and return on equity add another view by comparing profit to what your business owns or has invested.
What is a good profit margin?
A good profit margin varies widely by industry, so it's best to compare against similar businesses rather than a single benchmark. As a general guide, a higher net profit margin means more of each sale reaches your bank account.
Why is profitability important for a small business?
Profitability shows whether your business is efficient enough to sustain and grow itself over time. Watching it helps you price well, manage costs and make confident decisions about where to invest.
Related terms
Learn more about profitability
Handy resources
Advisor directory
You can search for experts in our advisor directory
P&L template
Download a P&L template to help track your profitability
Instant profitability reports
Generate key reports at the click of a mouse with Xero accounting software
Disclaimer
This glossary is for small business owners. The definitions are written with their requirements in mind. More detailed definitions can be found in accounting textbooks or from an accounting professional. Xero does not provide accounting, tax, business or legal advice.