Farwah Jafri | October 14 2022
It is very crucial to measure the financial performance of your business especially when you have to manage your expenses and scale the profitability as well.
To monitor the success rate of the business there are so many different measures of profitability available that it becomes overwhelming for the business owner to select one.
All of these profitability ratios or metrics are important when it comes to measuring the profitability of your business. We will be discussing the basics of ratios of profitability and how they matter when it comes to a business.
Read along to find out:
o The critical importance of different profitability ratios and how can help in scaling a business
o Which of these profitability ratios is the most suitable for your business
Let’s get started:
Profitability ratios are a huge term defining different metrics which are used to measure a business’s profit. Different ratios consider the sales revenue, operating expenses (OPEX), the equity of the shareholders, and balance sheet assets to measure profitability.
For instance, if you are a shareholder in a company, the profitability ratios will showcase the existing position of your assets, their values, and how well they can generate profit.
Profitability ratios are divided into two categories – margin ratios and return ratios.
Margin Ratios – these ratios represent the ability to turn sales into prospective profits.
Return Ratios – these are the ratios that illustrate the ability of a company to generate wealth for the owner and the shareholders.
These two categories are further subdivided into 5 other ratios. These 5 ratios are termed as the most vital for different types of businesses.
You need to have a complete understanding of these profitability ratios so that you can scale up your business accordingly and add more profitability to your mix.
Margin ratios comprise three of the most crucial profitability ratios in the business world. They are Gross profit margin, Net profit margin, and Operating profit margin.
One of the most widely used ratios is the gross profit margin ratio. It is known to calculate the amount that is left after the cost of goods is sold (CoGS). All the numbers required to calculate this ratio are gathered from the income statement for the business.
To sum it up, a high gross profit margin will reflect a high efficiency of the revenue and vice versa.
Gross profit margin = (Total sales – Cost of goods sold) / Total sales
This ratio showcases how much the business is making a profit after all the expenses (operating and non-operating ones) are paid off.
A high value of net profit margin shows that the company is moving upwards and is generating income and successfully operating its business operations.
To calculate the net profit margin, you need to have the values of revenue and net income, which can easily be taken from the income statement.
Net profit margin = Net income/ Revenue
The operating profit margin is also termed as EBIT (earnings before interest and taxes). This is the profit margin on the sales before the taxes and interest are deducted.
The operating costs are the expenses like rent, salaries, utilities, and other general costs. They are deducted from the gross profit.
The operating profit margin is one of the most commonly used assessment tools to determine whether a business is prospering or not.
Operating profit margin = Operating profit / Revenue
The return ratios are further subdivided into two categories. They are Return on assets and Return on equity.
The return ratios determine how much profit the business will generate for the shareholders or the owner.
See Also: The 3 Types of Profit Margins and What They Tell You
ROA (Return on Assets) mainly focuses on the efficiency of utilizing all the available assets to generate profitability. The ROA informs the business owners how well their resources are being put to use and generating profit.
The formula to calculate the rate on assets is:
Return on Assets= Net income / Total assets
The Return on Equity is considered one of the most critical profitability ratios, especially for the investors and shareholders of a business.
The ROE is measured by the return on investment. If the return on equity is high, It can be crucial in attracting new investors to the company.
The formula used to calculate return on equity is:
Return on Equity = Net income/ Average shareholder’s equity
It can be quite a cumbersome job to manage the finances of a business, on top of that is to achieve profitability and maintain it as well. This is where the profitability ratios come into the picture. They can help in measuring the success by exposing those areas of the business which might have been involuntarily neglected by the owners and need immediate attention.
Profitability ratios play a critical role in attracting new investors through return on assets as well as in the creation of future plans of how to sustain that profitability and upscale the business.
See Also: How Does Traditional Accounting In The Back Office Work?
Farwah is the Product Owner of Monily. She has an MBA from Alliance Manchester Business School, UK. She is passionate about helping businesses overcome challenges that hamper their growth, which is why she is working at Monily to facilitate entrepreneurs to efficiently manage business finances and stay focused on growth.