Profitability ratios: definition, types and formulas

Published Wednesday 1 April 2026

Table of contents

• What do profitability ratios measure?
• Why profitability ratios matter to your business
• How profitability ratios compare to other financial metrics
• Types of profitability ratios
• Understand your financial statements
• Gross profit margin
• Net profit margin
• Return on assets
• Return on invested capital
• Use profitability ratios in your business
• FAQs on profitability ratios

Key takeaways

• Calculate your gross profit margin and net profit margin monthly to track your core operational profitability, as these ratios show what percentage of revenue remains after covering direct costs and all expenses respectively.
• Use return on assets (ROA) and return on invested capital (ROIC) to evaluate whether your investments in equipment, property, or growth initiatives are generating adequate returns for your business.
• Establish baseline measurements for your current ratios, set benchmarks you want to maintain, and define improvement goals to track your financial performance over time.
• Compare your profitability ratios alongside liquidity and efficiency ratios to get a complete picture of your business health, since you can be profitable but still face cash flow issues.

What do profitability ratios measure?

Profitability ratios measure how efficiently your business turns revenue and investments into profit. Different ratios focus on different types of spending, so not all of them will be relevant to every small business.

Why profitability ratios matter to your business

Profitability ratios give you a clear picture of your business's financial health, going beyond just sales numbers. With how financial performance is presented undergoing its most significant change in over 20 years, understanding these ratios helps you make smarter decisions to support sustainable growth.

They help you:

• see the true financial health of your business
• guide pricing strategies and cost-control decisions
• find opportunities to improve efficiency
• plan for sustainable, long-term growth
• compare your performance over time and against industry benchmarks

How profitability ratios compare to other financial metrics

While profitability ratios are essential, they work best alongside other financial metrics. Each type of ratio tells a different part of your business's story.

• Profitability ratios vs liquidity ratios: Profitability ratios measure how well you generate profit, while liquidity ratios (like the current ratio) measure your ability to pay short-term debts.
• Profitability ratios vs efficiency ratios: Profitability ratios focus on the bottom line, while efficiency ratios (like inventory turnover) show how well you use your assets and manage liabilities.

A business can be profitable but still face cash flow issues, which is why it's important to look at all types of ratios together.

Types of profitability ratios

Profitability ratios fall into two main categories, each measuring a different aspect of your business performance.

Margin ratios

Margin ratios focus on your day-to-day spending, also called what you spend on operations. They show what percentage of revenue your business keeps versus what goes back out to cover costs, though how you calculate can vary; one study found companies calculating operating profit in at least nine different ways.

The two main margin ratios are:

• Gross profit margin: measures profit after direct costs
• Net profit margin: measures profit after all expenses

Return ratios

Return ratios focus on big-ticket investments. They're most relevant to businesses in growth mode, as they measure the return on expensive growth initiatives.

The two main return ratios are:

• Return on assets (ROA): measures profit generated from all assets
• Return on invested capital (ROIC): measures profit from new investments

Understand your financial statements

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

To calculate profitability ratios, you'll need figures from your key financial statements.

• The income statement: This is where you'll find your revenue, cost of goods sold (COGS), and other expenses needed for margin ratios.
• The balance sheet: This statement lists your assets and equity, which are used to calculate return ratios.

With accounting software like Xero, this information is organised and updated automatically, so you can find the numbers you need in just a few clicks.

Gross profit margin

Gross profit margin shows what percentage of revenue remains after paying for the products or services you sell. This is the cash you use to cover general expenses like rent, utilities, marketing, and administration. A healthy gross margin gives you more room to pay these costs and still turn a profit.

Why it matters

A higher gross margin benefits your business in several ways:

* 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.

• Retain more cash: You keep a bigger portion of each sale
• More flexible: You have more room to cover operating costs
• Early warning system: Tracking margins helps you spot threats to sustaining your operations
• Grow your business: You can identify ways to improve performance

How to calculate gross profit margin

For more detail, see the guides on how to measure profitability and how to increase profit.

Net profit margin

Net profit margin shows what percentage of revenue remains after paying all expenses. This is the money you keep in the business to pay owners or reinvest in growth.

Why it matters

A higher net profit margin means you're efficient at turning sales into profits. Higher margins make you less reliant on big sales figures, which helps small businesses that can't work at scale.

Finding the right margin involves trade-offs:

• Lower prices: May increase sales volume and total profit
• Higher marketing spend: May bring more customers through the door
• More staff: May improve operations and customer experience

You'll need to balance margin and growth.

Net profit can be calculated before or after taxes. If you're using after-tax net profit, subtract taxes from your calculation.

How to calculate net profit margin

For more detail, see the guides on how to measure profitability and how to increase profit.

Return on assets

Return on assets (ROA) measures how effectively you generate profit from your assets, such as property, equipment, and tools. This ratio is most relevant if you've invested significantly in equipment, real estate, or intellectual property.

Why it matters

ROA helps you evaluate your investment decisions:

• High ROA: Suggests you're getting good value from your assets
• Low ROA: May indicate you've overinvested in certain areas

This formula uses total assets rather than average assets. Average values are typically used by businesses that frequently buy and sell assets, which doesn't reflect most small businesses.

How to calculate return on assets

Return on invested capital

Return on invested capital (ROIC) measures how effectively you generate profit from new investments. This ratio is most useful if you're spending significantly on property, equipment, intellectual property, or research and development.

Why it matters

ROIC helps you assess whether your investments are paying off, so you can make smarter spending decisions in the future.

How to calculate return on invested capital

Use profitability ratios in your business

Profitability ratios help you measure how efficiently your business turns costs and investments into profit. Tracking your gross and net profit margins is especially important as they're key to sustaining your operations.

Here's how to put these ratios to work:

1. Calculate your current ratios to establish a baseline
2. Set benchmarks for the ratios you want to maintain
3. Define goals for the ratios you want to achieve
4. Monitor regularly to track progress over time

ROA and ROIC become more relevant as you scale your business, as professional investors use these types of metrics. For instance, a Chartered Financial Analyst (CFA) Institute survey found that 46% of analysts use earnings before interest and taxes (EBIT) in their analysis. Even if you don't calculate them formally, remember the core principle: every investment should pay for itself and generate additional returns.

Work with your accountant or bookkeeper to identify which ratios matter most for your business. They can run the calculations and share reports easily using software like Xero.

FAQs on profitability ratios

Still have questions about profitability ratios? Here are answers to some common concerns.

What is a good profitability ratio for a small business?

A 'good' ratio varies widely by industry. It's best to compare your ratios to your past performance and to benchmarks for your specific industry. The goal is steady improvement over time.

How do profitability ratios differ from liquidity ratios?

Profitability ratios measure your ability to generate profit from revenue and assets. Liquidity ratios measure your ability to meet short-term cash obligations. A business can be profitable but still have poor liquidity.

Which profitability ratio should I focus on first?

For most small businesses, the gross profit margin and net profit margin are the most important to track first. They give you a direct look at your core operational profitability, and tracking such custom metrics is a growing trend—among Standard & Poor's (S&P) 500 companies, their use increased from 65% to 85% between 2013–2022.

Can I have good profitability ratios but poor cash flow?

Yes. Profitability is an accounting measure, while cash flow tracks the actual cash moving in and out of your business. For example, you can have high profits from sales on credit, but if customers don't pay on time, your cash flow will suffer.

How often should I calculate my profitability ratios?

It's a good practice to review your profitability ratios monthly. This aligns with standard corporate reporting, as research shows that 75% of companies that use alternative performance measures disclose them for interim periods. This allows you to spot trends, address issues quickly, and make timely decisions to keep your business on track.