Profitability ratios are financial metrics that help investors and analysts measure and evaluate the ability of a company to generate income and profit from its operations, assets, and equity. They indicate how efficiently a company uses its resources to create value for its shareholders. In this blog, we will explain what profitability ratios are, how to calculate them using formulas and examples, and how to interpret them using benchmarks and comparisons.

What are Profitability Ratios?

Profitability ratios are ratios that compare some measure of profit to some measure of the size of the business. They can be classified into two main categories: margin ratios and return ratios. Margin ratios show how much profit a company makes for every dollar of sales, while return ratios show how much profit a company generates for every dollar of investment. Some of the most commonly used profitability ratios are:

• Gross Profit Margin: This ratio measures the percentage of revenue that is left after deducting the cost of goods sold (COGS), which are the direct costs of producing or delivering the goods or services. It shows how well a company manages its production or inventory costs and how much it can mark up its products or services. The formula for gross profit margin is:

Gross Profit Margin=RevenueGross Profit​×100%

where Gross Profit = Revenue – COGS

• Operating Profit Margin: This ratio measures the percentage of revenue that is left after deducting both the cost of goods sold and the operating expenses, which are the indirect costs of running the business, such as salaries, rent, utilities, marketing, etc. It shows how well a company controls its operating costs and how profitable its core business activities are. The formula for operating profit margin is:

Operating Profit Margin=RevenueOperating Profit​×100%

where Operating Profit = Revenue – COGS – Operating Expenses

• Net Profit Margin: This ratio measures the percentage of revenue that is left after deducting all the expenses, including the cost of goods sold, the operating expenses, the interest expenses, the taxes, and any other income or expenses. It shows how much profit a company earns for every dollar of sales after paying all its obligations. It is also known as the bottom line or net income ratio. The formula for net profit margin is:

Net Profit Margin=RevenueNet Profit​×100%

where Net Profit = Revenue – COGS – Operating Expenses – Interest Expenses – Taxes + Other Income or Expenses

• Return on Assets (ROA): This ratio measures the percentage of profit a company earns for every dollar of assets it owns. Assets are the resources that a company uses to generate income, such as cash, inventory, equipment, property, etc. It shows how efficiently a company utilizes its assets to produce profit and value for shareholders. The formula for return on assets is:

Return on Assets=Average Total AssetsNet Profit​×100%

where Average Total Assets = (Beginning Total Assets + Ending Total Assets) / 2

• Return on Equity (ROE): This ratio measures the percentage of profit a company earns for every dollar of equity it has. Equity is the amount of money that the owners or shareholders have invested in the company, or the difference between the total assets and the total liabilities. It shows how effectively a company uses its equity to generate profit and value for shareholders. The formula for return on equity is:

Return on Equity=Average Shareholders’ EquityNet Profit​×100%

where Average Shareholders’ Equity = (Beginning Shareholders’ Equity + Ending Shareholders’ Equity) / 2

How to Calculate Profitability Ratios Using Examples

To illustrate how to calculate profitability ratios, let’s use the following financial data from Company A and Company B for the year 2023:

Item	Company A	Company B
Revenue	$100,000	$80,000
COGS	$40,000	$30,000
Operating Expenses	$20,000	$25,000
Interest Expenses	$5,000	$10,000
Taxes	$10,000	$5,000
Other Income	$2,000	$1,000
Beginning Total Assets	$200,000	$150,000
Ending Total Assets	$220,000	$160,000
Beginning Shareholders’ Equity	$100,000	$80,000
Ending Shareholders’ Equity	$110,000	$90,000

Using the formulas above, we can calculate the profitability ratios for both companies as follows:

Ratio	Company A	Company B
Gross Profit Margin	($100,000 – $40,000) / $100,000 x 100% = 60%	($80,000 – $30,000) / $80,000 x 100% = 62.5%
Operating Profit Margin	($100,000 – $40,000 – $20,000) / $100,000 x 100% = 40%	($80,000 – $30,000 – $25,000) / $80,000 x 100% = 31.25%
Net Profit Margin	($100,000 – $40,000 – $20,000 – $5,000 – $10,000 + $2,000) / $100,000 x 100% = 27%	($80,000 – $30,000 – $25,000 – $10,000 – $5,000 + $1,000) / $80,000 x 100% = 13.75%
Return on Assets	($100,000 – $40,000 – $20,000 – $5,000 – $10,000 + $2,000) / (($200,000 + $220,000) / 2) x 100% = 12.73%	($80,000 – $30,000 – $25,000 – $10,000 – $5,000 + $1,000) / (($150,000 + $160,000) / 2) x 100% = 8.67%
Return on Equity	($100,000 – $40,000 – $20,000 – $5,000 – $10,000 + $2,000) / (($100,000 + $110,000) / 2) x 100% = 25.45%	($80,000 – $30,000 – $25,000 – $10,000 – $5,000 + $1,000) / (($80,000 + $90,000) / 2) x 100% = 17.33%

How to Interpret Profitability Ratios Using Benchmarks and Comparisons

Profitability ratios can provide useful insights into the financial performance and health of a company. However, they should not be used in isolation, but rather in comparison with other relevant information, such as:

• The company’s own historical performance: Comparing the current profitability ratios with the previous periods can reveal the trends and changes in the company’s profitability over time. For example, an increasing gross profit margin may indicate an improvement in production efficiency or pricing strategy, while a decreasing net profit margin may indicate a decline in sales or an increase in costs.
• The industry average or benchmark: Comparing the company’s profitability ratios with the industry average or a similar company can reveal the relative strengths and weaknesses of the company’s profitability in the market. For example, a higher operating profit margin than the industry average may indicate a competitive advantage in cost control or product differentiation, while a lower return on equity than the industry average may indicate a lack of growth opportunities or a high debt burden.
• The company’s goals or expectations: Comparing the company’s profitability ratios with its own goals or expectations can reveal the degree of achievement or deviation of the company’s profitability from its desired level. For example, a higher net profit margin than the expected level may indicate a better than expected performance or a favorable external environment, while a lower return on assets than the expected level may indicate a poor performance or an unfavorable external environment.

Using the examples above, we can interpret the profitability ratios of Company A and Company B as follows:

• Company A has a higher operating profit margin, net profit margin, return on assets, and return on equity than Company B, indicating that Company A is more efficient and effective at generating profit from its sales, assets, and equity than Company B.
• Company B has a slightly higher gross profit margin than Company A, indicating that Company B has a lower cost of goods sold than Company A, but this advantage is offset by its higher operating expenses, interest expenses, and taxes, which reduce its net profit margin.
• Both companies have profitability ratios that are lower than the industry average of 70% for gross profit margin, 50% for operating profit margin, 35% for net profit margin, 20% for return on assets, and 30% for return on equity, indicating that both companies are less profitable than their peers in the industry.
• Both companies have profitability ratios that are higher than their own goals or expectations of 50% for gross profit margin, 30% for operating profit margin, 20