As previously mentioned, profitability ratios measure the capability of a company to generate profit in relation to various line items on its financial statements. The profitability ratio formula will vary based on which ratio is being calculated. Below are some of the most common profitability ratios.
Gross Profit Margin
Gross profit margin is calculated by subtracting the cost of goods sold (COGS) from net sales (gross profit) and then dividing by net sales.
Gross Profit Margin = (Net Sales - COGS) / Net Sales
The gross profit margin is often expressed as a percentage, which can be found by multiplying the result of the equation above by 100. This shows the portion of sales attributable to profit before accounting for operating costs.
EBITDA Margin
The EBITDA margin can be found by summing earnings before interest and tax (EBIT) depreciation and amortization and then dividing by total revenue.
EBITDA Margin = (EBIT + Depreciation + Amortization) / Total Revenue
This ratio measures the operating expenses of a company compared to its total revenue. A high EBITDA margin is desirable because it is indicative that operating expenses are relatively low compared to the total revenue for the company.
Operating Profit Margin
Also known at the EBIT margin, the operating profit margin is found by dividing the operating profit, or EBIT, by the total revenue for the company.
Operating Profit Margin = EBIT / Total Revenue
This ratio is also often expressed as a percentage, which can be found by multiplying the result of the equation by 100. This shows how good a company is at controlling its costs to optimize its profitability, and is a strong indicator of the capability of the top management.
Net Profit Margin
The net profit margin is found by dividing net income by revenue:
Net Profit Margin = Net Income / Total Revenue
Net income is the profit generated by a company after subtracting all operating costs, costs of goods sold, interest, and taxes. This shows what portion of total revenue is attributable to profit. It is often used similarly to operating profit margin—to assess upper management and their capability of successfully running the company.
Cash Flow Margin
The cash flow margin is calculated by dividing operating cash flow by total revenue.
Cash Flow Margin = Operating Cash Flow / Total Revenue
This financial ratio shows how effectively a company can turn sales into cash. A higher ratio indicates that the company is doing a good job of converting its sales into cash. However, as with all the ratios, it needs to be analyzed in comparison to the historic cash flow margins for the company as well as its competitor cash flow margins.
Return on Assets
Return on assets, or ROA, measures how well a company utilizes its assets to generate profit. It is calculated by dividing net income by total assets.
ROA = Net Income / Total Assets
As with the other ratios, a higher ROA is desirable because it indicates the company is doing a good job at utilizing its asset to produce profit. However, it must be analyzed within the context of its industry: service-oriented businesses might have less assets and be able to produce a higher ROA. However, companies that require tons of assets to operate may generally have a lower ROA, so it needs to be compared to industry competitors to actually determine if the ROA is good or not.
Return on Equity
Return on equity, or ROE, measures how effectively a company can utilize its equity financing, or shareholder investments, to create profit. It is calculated by dividing net income by shareholder equity.
ROE = Net Income / Shareholder Equity
Much like ROA, what constitutes a good ROE will depend on the industry in which the company is operating. It must be analyzed in comparison to industry competitors to determine if the company has a good ROE or not.
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FAQs
Profitability Ratios Examples
What is profitability ratio and examples? ›
Profitability ratios assess a company's ability to earn profits from its sales or operations, balance sheet assets, or shareholders' equity. They indicate how efficiently a company generates profit and value for shareholders. Profitability ratios include margin ratios and return ratios.
Which three are examples of profitability ratios? ›
The three main profitability ratios are return on sales, return on equity, and earnings per share. Return on sales is calculated by dividing net income after taxes by net sales. Return on equity is calculated by dividing net income after taxes by total equity.
What is the basic profitability formula? ›
Gross profit margin = gross profit / sales x 100
Gross profit is your revenue minus your cost of goods sold (COGS), which includes raw materials. You calculate the gross profit margin by dividing gross profit by revenue.
What is a profitability example? ›
Profitability is measured with income and expenses. Income is money generated from the activities of the business. For example, if crops and livestock are produced and sold, income is generated. However, money coming into the business from activities like borrowing money do not create income.
What are profitability ratios for dummies? ›
Profitability ratios can be separated into two categories: return ratios and margin ratios. Return ratios measure the return the company produces for its shareholders while margin ratios measure how well the company can generate a profit from its sales.
How do you calculate the profit ratio? ›
It represents the percentage of each dollar of sales that is kept as profit after deducting all expenses, including operating expenses, taxes, interest, and depreciation. The profit ratio is calculated by dividing the net profit by the total revenue of the company and expressing the result as a percentage.
What is the most widely used profitability ratio? ›
Gross profit margin is the most widely used margin ratio. It calculates the amount left over after covering cost of goods sold (CoGS). The numbers needed to calculate this ratio are found on your business' income statement.
What is an example of a ratio calculation? ›
If you are comparing one data point (A) to another data point (B), your formula would be A/B. This means you are dividing information A by information B. For example, if A is five and B is 10, your ratio will be 5/10. Solve the equation. Divide data A by data B to find your ratio.
How to calculate the profitability of a company? ›
Gross Profit = Net Sales – Cost of Goods Sold. Operating Profit = Gross Profit – (Operating Costs, Including Selling and Administrative Expenses) Net Profit = (Operating Profit + Any Other Income) – (Additional Expenses) – (Income Taxes)
Operating profit = Net sales – (Cost of goods sold + Administrative and office expenses + Selling and distribution exp.) Since, the operating profit ratio is expressed as a percentage, therefore we need to multiply by 100, the value obtained by the division of operating profit with the net sales.
What is the profitability formula framework? ›
Profits = Revenues – Costs
Revenue depends on how much of its products and services a company sells and at what price. Costs depend on fixed costs and variable costs. Quantity sold is the amount of goods or services sold in a period of time.
What is profitability ratio with example? ›
Earnings per share or EPS is a profitability ratio that measures the extent to which a company earns profit. It is calculated by dividing the net profit earned by outstanding shares. Having higher EPS translates into more profitability for the company.
How do u calculate profit? ›
The basic formula that is used to calculate the profit in a business or a financial transaction, is: Profit = Selling Price - Cost Price. Here, Cost Price (CP) of a product is the cost at which it was originally bought. Selling Price (SP) of the product is the cost at which it was is sold.
What is the difference between profit and profitability formula? ›
Profit is the amount your business gains. It is a number that remains when you subtract expenses from your revenue. You can find profit by looking at your business's income statement. Profitability measures your business's profits and helps you determine your success or failure.
What is an example of operating profit ratio? ›
For example, say company A has an operating profit ratio of 17% while company B has this value at 19%. It is safe to say here that investing in company B shows better promise given the fact that its operating profit ratio proves its efficiency.
What is a good profit ratio? ›
An NYU report on U.S. margins revealed the average net profit margin is 7.71% across different industries. But that doesn't mean your ideal profit margin will align with this number. As a rule of thumb, 5% is a low margin, 10% is a healthy margin, and 20% is a high margin.
What is the best measure of profitability? ›
A good metric for evaluating profitability is net margin, the ratio of net profits to total revenues.
What is an example of liquidity ratio? ›
A ratio of 1 means that a company can exactly pay off all its current liabilities with its current assets. A ratio of less than 1 (e.g., 0.75) would imply that a company is not able to satisfy its current liabilities. A ratio greater than 1 (e.g., 2.0) would imply that a company is able to satisfy its current bills.
