Profitability Ratios: Understand and Improve Your Profits

Published Thursday 8 January 2026

Table of contents

• What do profitability ratios measure?
• Types of profitability ratios
• Understanding each profitability ratio
• Using profitability ratios in your business
• Track your profitability ratios with confidence
• FAQs on profitability ratios

Key takeaways

• Calculate gross profit margin and net profit margin monthly to monitor your business's operational efficiency and identify trends early, as these ratios reveal how much revenue remains after covering direct costs and all expenses respectively.
• Focus on maintaining substantial gross profit margins since you need this remaining cash to cover operating expenses like rent, utilities, and marketing, while avoiding practices like heavy discounting that can quickly erode your margins.
• Apply return on assets (ROA) and return on invested capital (ROIC) ratios when your business makes significant investments in equipment, property, or other assets to ensure these investments generate adequate returns and guide future spending decisions.
• Establish industry-appropriate benchmarks for your ratios, aiming for gross margins above 50% and net margins above 10% as starting points, while recognising that good ratios vary significantly by industry and business model.

What do profitability ratios measure?

Profitability ratios are financial metrics that measure how efficiently your business converts spending into profits. They help you understand which areas of your business generate the best returns.

Different ratio types focus on specific spending categories. Not every ratio will be relevant to your small business.

Types of profitability ratios

Profitability ratios fall into two main categories, each measuring different aspects of your financial performance:

Margin ratios

Margin ratios measure your day-to-day operational efficiency. They show what percentage of revenue you keep after covering various costs.

Key margin ratios include:

• Gross profit margin: Revenue remaining after direct costs
• Net profit margin: Revenue remaining after all expenses

Return ratios

Return ratios measure how effectively you generate profits from major investments. These ratios are most relevant for growing businesses with significant assets or capital expenditure.

Key return ratios include:

• Return on assets (ROA): Profit generated from total assets
• Return on invested capital (ROIC): Profit generated from new investments

Understanding each profitability ratio

1. Gross profit margin

Gross profit margin shows what percentage of revenue remains after paying for the direct costs of your products or services.

This margin needs to be substantial because you'll use this remaining cash to cover operating expenses, and practices like heavy discounting, which in one case study accounted for 9.4% of total income, can quickly erode it. These operating expenses include rent, utilities, marketing, insurance and administration costs.

Why it matters

Higher gross margins give you important advantages:

• Greater cash retention: Keep more of each sale for operating expenses
• Improved sustainability: More runway to cover costs and generate profit
• Performance insights: Early warning system for threats and opportunities

Formula for calculating gross profit margin ratio

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 business expenses; for example, one analysis of a sample company found a calculated Net profit margin of 8.5%. This is your true profit from each sale.

Why it matters

Higher net profit margins signal operational efficiency. They reduce your dependence on high sales volumes, which benefits small businesses without economies of scale.

Finding your optimal margin requires strategic balance:

• Lower prices: Increase sales volume to boost total profits
• Maintain prices: Invest extra revenue in marketing for customer acquisition
• Invest in staff: Improve operations and customer experience

* 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 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.

3. Return on assets

Return on assets (ROA) measures how effectively you generate profit from your business assets like property, equipment, and tools.

This ratio is most relevant for businesses with significant investments 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 or are managing assets poorly, such as in one case where 15% of destroyed stock occurred without supervision.

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.

* Use the value of assets rather than the average value of assets. Average values suit businesses that buy and sell assets all the time, which is less typical for small businesses.

4. Return on invested capital

Return on invested capital (ROIC) measures profit generated from new business investments.

This ratio applies primarily to businesses making substantial investments in property, buildings, equipment, intellectual property, or research and development.

Why it matters

ROIC shows which assets or projects deliver strong returns, so you can focus future investment on what works best.

Formula for calculating return on invested capital ratio

Using profitability ratios in your business

Profitability ratios help small businesses measure how efficiently they convert costs into profits. Track these metrics to maintain financial health and guide business decisions.

Start with these essential ratios:

• Gross profit margin: Monitor operational efficiency
• Net profit margin: Track overall profitability

Use your ratios to establish benchmarks and set improvement goals.

Advanced ratios for growing businesses:ROA and ROIC become more relevant as your business grows. Even without formal measurement, apply their core principle: investments must generate returns.

Getting professional support:Work with accountants or bookkeepers to identify relevant ratios for your business. They can calculate these metrics and generate reports through software like Xero.

Track your profitability ratios with confidence

Understanding profitability ratios gives you powerful insights into your business performance. Start by monitoring your gross and net profit margins monthly to spot trends and opportunities.

Ready to simplify your financial tracking? Xero's accounting software automatically calculates profitability ratios from your business data. You'll get clear reports that help you make informed decisions about pricing, costs, and growth investments.

Try Xero for free and see how easy financial management can be.

FAQs on profitability ratios

Understanding profitability ratios often raises follow-up questions. Here are the most common queries from small business owners.

How often should I calculate profitability ratios?

Calculate your ratios monthly to spot trends early and make timely business adjustments.

What's considered a good profitability ratio for small businesses?

Good ratios vary by industry; for instance, a 10% net profit margin may be good for retail but would be considered low for a SaaS company. As a starting point, however, you can aim for gross margins above 50% and net margins above 10%.

Which profitability ratio is most important to track?

Gross profit margin is typically most critical as it directly impacts your ability to cover operating expenses and generate profit.