What Are Profitability Ratios in Accounting?

Every business owner wants to run a successful, profitable company. However, understanding how to measure your profitability can feel challenging. That’s where profitability ratios come in handy.

Profitability ratios help you understand how efficiently you’re generating profit and identify areas of your operations where you can improve.

It’s important for every business owner to be able to calculate different types of profitability ratios and understand their significance. Keeping a close eye on them regularly helps your business run efficiently and remain profitable as it grows.

What Are Profitability Ratios?

Profitability ratios are calculations that measure a company’s ability to generate profit relative to other factors like revenue, operating costs, assets and equity. 

These ratios are expressed as percentages. A net profit margin of 20%, for instance, means that for every dollar you earn, 20 cents is kept by you as net profit.

Higher margins indicate that your company’s strategies are efficient and that your operations are being managed well. Lower margins indicate that there’s room for improvement.

As long as your accounting is well-organized and up-to-date, profitability ratios are fairly simple to calculate. However, don’t be deceived by their simplicity; these ratios can provide valuable insights into the current health of your business.

What Can Profitability Ratios Tell You?

Whether you’re running a startup or a well-established company, you should be using profitability ratios as a guide for your decision-making process. Profitability ratios can tell you many things about your current operations, such as:

How Efficient You Are

Profitability ratios can give you a good sense of whether you’re using your resources to their fullest potential in order to produce a profit. If your margins are looking a bit slim, analyzing your ratios can help you figure out key areas to improve your efficiency.

Your Long-term Sustainability as a Company

Are you making smart decisions and managing your company well? Profitability ratios can help you understand your long-term sustainability at your current operating rate. It can also give you a sense of whether you can maintain your current profit levels, or if you need to make improvements to increase profits.

Your Investment Potential

If you’re seeking new sources of funding, potential investors will want to look at your net profit margins, return on equity, and other ratios to better understand your value and potential as a company. These numbers can make or break whether you get that investment you need, so it’s worth keeping an eye on them as you do your accounting. 

Performance Trends

How well is your company doing? Profitability ratios can give you insight into your general performance trends over time, helping you set benchmarks and understand if you’re meeting your goals.

What are the Most Common Types of Profitability Ratios?

There are a number of profitability ratios that companies commonly use when doing their accounting. Let’s look at what they’re used for and the formulas needed to calculate them. 

Gross Profit Margin

Gross profit margin is an indication of the percentage of your revenue left after accounting for the cost of goods sold (COGS). This ratio reflects on how efficient your production and pricing strategies are.

Gross Profit Margin = ((Revenue – COGS) / Revenue) x 100

Operating Profit Margin

Operating profit margin is a measure of how much revenue you retain after paying your operating expenses. Operating profit margin excludes taxes and interest.

Operating Profit Margin = (Operating Income / Revenue) x 100

Net Profit Margin

Also referred to as the bottom line, net profit margin reflects how profitable your company is after taking all expenses, including taxes and interest, into account.

Net Profit Margin = (Net Income / Revenue) x 100

Cash Flow Margin

Cash flow margin takes into account all transfers of money within your company and measures how efficiently you’re converting sales to cash. Many businesses struggle with cash flow, so this is an important ratio to understand.

Cash Flow Margin = (Operating Cash Flow / Revenue) x 100

Return on Assets (ROA)

ROA is a measure of how efficiently your company is using its assets to generate profit. This ratio is fairly dependent on the industry you’re in. Software companies that only sell digital products have far fewer assets to account for than manufacturing companies, which rely heavily on machinery and other physical assets.

ROA = (Net Income / Total Assets) x 100

Return on Equity (ROE)

ROE measures the return generated by the money investors have put into your business. If you’re looking for future investments or talking to current shareholders, most will ask to see your ROE to understand how effectively you’re using equity to generate profits.

ROE = (Net Income / Shareholders’ Equity) x 100

What Factors Impact Profitability Ratios?

Now that you understand what profitability ratios are, let’s explore the factors that influence them.

Cost Management

From production costs to operational costs, there are a lot of expenses when it comes to running a business. Managing your assets wisely, streamlining your operations and cutting out unnecessary costs can go a long way to improve your margins.

Revenue

Increasing your sales numbers or raising your prices—while keeping costs steady—can make your company more profitable.

Interest and Debt

High interest can eat into your bottom line and impact how profitable your company is. It’s vital to pay off high interest loans, manage any debts and make smart decisions about securing future funding for your company.

Market Conditions

As we’ve learned all too well this decade, market conditions have a huge impact on all businesses. Economic downturns, rising interest rates, changes in the price of raw materials or new competitors can all shrink your margins. Nearly half of all small business owners say that inflation had a significant impact on their cash flow in 2023. 

Always stay aware of changes in the market and be willing to change your strategies accordingly.

Get Help With Your Accounting

Profitability ratios are a key tool for every company, helping you assess your financial performance and streamline your operations.

If you’re ready to make your business more profitable and simplify your monthly accounting, reach out to our team at Finvisor.

Our outsourced CFO services are tailored to the needs of your business. We can handle your bookkeeping and accounting, as well as offer financial insights and guidance so you can make informed decisions for your company.

Contact us today to get a quote and learn more about how our solutions can help you reach your business goals.