What Are Profitability Ratios? (Plus Types and Examples)

By Indeed Editorial Team

Published 16 May 2022

The Indeed Editorial Team comprises a diverse and talented team of writers, researchers and subject matter experts equipped with Indeed's data and insights to deliver useful tips to help guide your career journey.

Profitability ratios, or profit ratios, are financial metrics you can use to analyse a company's performance. There are several types of profit ratios that can you can calculate easily to assess a company's financial success and the number of returns it can offer shareholders. Assessing a company's finances throughout different points of the fiscal year can help you identify how well the company is doing financially and what it can do better to improve profitability in the future. In this article, we discuss what profitability ratios are and define the various types of profit ratios with detailed examples.

What are profitability ratios?

Profitability ratios, or profit ratios, refer to a set of financial metrics that companies use to assess and measure their ability to generate profits or income relative to their operating costs, revenue, investor's equity and balance sheet assets within a specific time period. These ratios present how an organisation uses its assets to generate profits and value for its investors. A higher profit ratio indicates that a company is performing well by generating revenues, cash flow and profits. Profit ratios are most important when they're compared to a company's competitors or previous fiscal periods.

Related: Variable Cost - Explanation, Benefits and Example

Types of profit ratios

There are various profit ratios that you can use to gain insight into the financial performance and welfare of a company. Each ratio belongs to one of the following categories:

  • Margin ratios: These serve as an organisation's ability to turn sales into profits at various cost levels and degrees of measurement. Some examples of margin ratios include net profit margin, operating profit margin, cash flow margin, operating expense ratio, gross profit margin and overhead ratio.

  • Return ratios: These represent the return an organisation can give its shareholders. Some examples of return ratios include return on revenue, return on retained earnings, return on assets, cash return on assets, return on equity, return on capital employed, risk-adjusted return and return on debt.

There are several profit ratios that companies use to analyse productivity by comparing income to equity, sales and assets. Here are some of the most commonly used profit ratios:

Gross profit margin

Gross profit margin compares a company's gross profit to its sales revenue. It shows how much a company is earning, taking the needed costs into account to produce its services and goods. To calculate a company's gross profit margin percentage, subtract the cost of goods sold (COGS) from the net sales. You can then divide this figure by net sales to calculate a company's gross profit margin in percentage terms.

A high-profit margin ratio indicates a higher efficiency of a company's core operations. This means it can still cover dividends, fixed costs, depreciation and operating expenses, while also giving net earnings to the company. Conversely, a low-profit margin reflects a high cost of goods sold, which might be due to low selling prices, adverse purchasing policies, stiff market competition, low sales and wrong sales promotion policies.

Related: 9 Types of Sales Commission Structures and How to Choose One

Operating profit margin

Operating profit margin allows organisations to see their earnings before deducting interest expenses and taxes from investments. To calculate the operating margin, just divide the organisation's operating income by its sales or revenues. Organisations that have a high operating profit margin can pay off shareholders, debt and other financial obligations. They can also endure fluctuations in the economy and offer lower prices compared to their competitors that have a lower profit margin.

EBITDA margin

EBITDA, which stands for Earnings Before Interest, Taxes and Amortisation, represents an organisation's profitability before deducting any non-operating costs. These non-operating costs are items such as amortisation, depreciation, taxes and interest that aren't taken into account. Companies often use EBITDA in place of net income earnings, as it offers a more exact measure of a company's performance because it shows the company's profitability before accounting and financial deductions. To calculate EBITDA, take sales revenue and deduct operating expenses, such as the cost of goods sold and selling, administrative and general expenses, but exclude amortisation and depreciation.

Net profit margin

Net profit margin can also give you an idea of how profitable an organisation is. You can calculate the net profit margin by taking a company's net income and dividing it by its total revenue. This ratio takes taxes and interest into account, including every other expense an organisation has. Remember that you can't compare the historic financial value to other companies, as the metric includes onetime gains and expenses that don't follow the same trends each fiscal year.

Return on equity

Return on equity (ROE) expresses the percentage of a company's net income relative to stockholders' equity, or the rate of return on the money that equity investors have put into the company. The ROE ratio is one that investors and stock analysts particularly watch. They often cite a favourably high ROE ratio as a reason to purchase a company's stock. To calculate ROE, simply divide the organisation's net income by its average shareholders' equity. Organisations with a high ROE are often more capable of generating cash internally, and thus less dependent on debt financing.

Related: What Is Equity Research? (Plus How to Establish a Career in the Field)

Cash flow margin

Cash flow margin describes the correlation between operating cash flow and the sales that the company generated. This ratio measures how an organisation converts sales into cash. To calculate cash flow margin, simply divide cash flow from operations by net sales. A high percentage of cash flow allows organisations to have more cash available to pay utilities, service debt, suppliers and dividends. Conversely, a negative cash flow margin causes organisations to lose money, even if they're generating sales or profits. Companies with inadequate cash flow may choose to borrow money or raise money from investors to continue operating.

Return on assets

Return on assets (ROA) refers to the percentage of a company's net earnings relative to its total assets. It discloses how much profit an organisation generates after taxes for every one dollar of assets it holds. Also, this ratio measures how asset-intense an organisation is. To calculate ROA, simply divide a company's net income by the average of its total assets.

Organisations with high asset intensity require large investments to purchase machinery or equipment to make profits. Some examples of industries that are asset intensive include telecommunication services and car manufacturers. Examples of less asset-intensive industries include software companies and advertising industries.

Return on invested capital

Return on invested capital represents the measures generated by each provider of capital, such as bondholders and shareholders. It's similar to the return on equity ratio, but more all-encompassing in its scope, as it includes returns generated from capital that bondholders supplied. Companies often use return on invested capital because it represents income made before deducting interest expenditures, and thus represents earnings that are available to all shareholders and investors. To calculate return on invested capital, just subtract cash and non-interest-bearing current liabilities, including tax liabilities and accounts payable, from total assets.

Examples of profitability ratios

There are many ways to use profit ratios in business to determine any margin or return that a company may have or give to shareholders and bondholders. Here are a few examples you may consider to deepen your understanding of profit ratios:

Gross profit margin example

Here's a sample calculation of gross profit margin:

New Company earns $30 million in revenue by producing apps and incurs $12 million in cost of goods and services or COGS-related expenses. New Company's profit is $30 million minus $12 million. Businesses can calculate the gross margin as the gross profit of $18 million divided by $30 million, which is 0.60 or 60%. This means New Company earns 60 cents per dollar in gross margin profit.

EBITDA example

Here's a sample calculation of EBITDA:

Wintergreen retail company generates $200 million in revenue and ends up with $80 million in production costs and $25 million in operating expenses. Amortisation and depreciation amount to a total of $15 million, which yields an operating profit of $80 million. Interest expenses are $5 million, which equals earnings before taxes amounting to $75 million. Net income equals $60 million after $15 million in taxes is subtracted using a tax rate of 20%. If you don't consider the cost of amortisation, depreciation, interest and taxes, EBITDA's net income equals $95 million.

Return on equity example

Here's a sample calculation of return on equity:

In the third quarter of the fiscal year, Diamond Bank Corporation reported a net income of $14 billion and their shareholders' equity was reported at $58.17 billion. You can calculate their ratio using this basic formula:

  • ROE = Net income/Shareholder equity OR 24.06% = $14 billion/$58.17 billion

If the standard ROE for the banking sector was 20%, then Diamond Bank Corporation exceeded the average ROE for their entire sector. This means that their shareholders generated 24 cents in profit for every dollar DBC made.

Explore more articles