4 Profitability Ratios Every Business Must Calculate

Investopedia defines Profitability Ratios as, “A class of financial metrics that are used to assess a business’s ability to generate earnings as compared to its expenses and other relevant costs incurred during a specific period of time. For most of these ratios, having a higher value relative to a competitor’s ratio or the same ratio from a previous period is indicative that the company is doing well.”

Profitability Ratios Help In:

• Gauging business performance
• Taking business decisions related to expansion or diversification
• Enabling lenders/investors get a clear picture of the business and make available additional resources

The important profitability ratios are:

Gross-Profit Ratio:

• Gross-Profit ratio shows how profitable your company utilizes its resources, materials, and labour
• It measures your business’s manufacturing and distribution efficiency during the production process
• Gross-Profit ratio is calculated as gross profit divided by total sales (revenue)
• A higher Gross-Profit ratio indicates that the business is cost-effective. Note that investors use the gross-profit ratio to compare the profitability of business’s in the same industry and also in different industries

Net-Profit Ratio:

• Net profit ratio is a key ratio of profitability
• It shows the amount of each sales rupee left over after all expenses have been paid
• Calculated as Profit (after tax) / Revenue
• A higher net profit ratio means that your business is more efficient at converting sales into actual profit

Operating Ratio or EBIT (Earnings Before Interest and Taxes):

• EBIT measures an entity’s profitability after excluding interest and income tax expenses
• It represents your business’s earning power from on-going operations.
• Calculated as Profit (loss) + Operating costs + Income tax expense

Cash Flow Margin Ratio:

• Cash-Flow Margin ratio is a key profitability ratio that gives insight into your company’s inner workings
• It measures how well the business’s operations are creating cash from sales
• It is calculated as = Cash flows from operating activities / Net sales
• A high cash flow margin indicates efficiency at debts collection and also a high earnings quality.