You Should Know What These 8 Profitability Ratios Mean

Even if you’re new to investing, you probably already know the importance of building a diversified portfolio that contains a variety of complementary assets. 
 
While many investors choose to invest through funds (leaving the individual stock picking to the pros), some still like to take a hands- on approach. If you’re in the second category, but unsure exactly how you should go about evaluating assets before you choose to invest in them, you’re going to want to learn about the various metrics investors look at. The specific strategies you may use will depend on the types of investments you are considering. When it comes to stocks and corporate bonds, it can be a good idea to look at a company’s profitability ratios. 
 
Below, we take a closer look at what profitability ratios are and why they’re so important. We also highlight eight of the most common profitability ratios that investors should be familiar with. 

What are profitability ratios? 

Profitability ratios are financial metrics that communicate information about a business’s ability to earn a profit relative to its other financial metrics—like revenue, shareholder equity, operating costs and more—at a specific moment in time.  

If these ratios are positive, it means that a company is profitable; if they are negative, it means that a company is unprofitable. Generally speaking, a company with a higher profitability ratio is better at earning a profit than a company with a lower ratio. 

It’s important to note that profitability ratios speak to a company’s past performance and aren’t necessarily capable of predicting future performance.  

Margin ratios vs. return ratios 

Profitability ratios are usually grouped into two main categories: margin ratios and return ratios.  

Margin ratios—like a company’s gross profit margin ratio, operating margin ratio, net profit margin ratio, pretax margin ratio and cash flow margin ratio—measure how well a company turns its sales and revenue into profit. 

Return ratios, on the other hand—like a company’s return on assets, return on equity and return on invested capital—measure how well a company generates returns for itself and its shareholders using the assets on its balance sheet. 

Investors should consider both types of ratios before deciding whether or not to invest in a particular company’s stocks or bonds.  

Why are profitability ratios important? 

A company’s profitability ratios are important because they give investors a snapshot into a business’s financial health and ability to earn a profit and return on investment. In other words, they’re a way of quickly quantifying how well a business makes money.    

Investors can use profitability ratios to: 

• Determine whether or not a company is profitable enough to warrant their investment, 

• Compare multiple businesses against each other before making an investment decision, 

• Track a business’s performance over time to see if it is performing better or worse,  

• and more 

The 8 most common profitability ratios 

1. Gross profit margin ratio 

A company’s gross profit margin ratio is a financial metric that compares a company’s gross profit—its revenue minus the cost of goods sold (COGS)—against its revenue. It’s calculated by subtracting a company’s COGS from its revenue, dividing that number by revenue and then multiplying it by 100: 

Gross Profit Margin Ratio = (Revenue - COGS) / Revenue X 100 

While revenue tells you the total amount of money that a company brings in from sales during the reporting period, gross profit margin ratio tells you how much of that revenue remains as profit after accounting for the cost of sales.  

Companies operating in the same industry will often have similar gross profit margins. If you identify a company that has a gross profit margin that is high compared to its peers, it may indicate that the company has the ability to charge a premium for its product—for example, due to strong brand recognition, high quality, or another competitive advantage.  

2. Operating margin ratio 

A company’s operating margin ratio indicates what percentage of revenue is left after accounting not only for the business’s COGS but also its operating expenses. This can include things like general and administrative expenses, as well as costs related to sales and marketing. What remains is a company’s earnings before interest and taxes, or EBIT. It’s calculated by dividing the company’s operating earnings by its revenue earned during the period and multiplying that number by 100: 

Operating Margin Ratio = (Operating Earnings / Revenue) X 100 

Investors can use a company’s operating margin ratio to evaluate how well a company keeps its operational costs in check. It can be particularly helpful in comparing companies in the same industry with similar structures but may be less helpful for comparing companies in different industries or with vastly different structures.  

3. Pretax margin ratio 

A company’s pretax margin ratio takes things a step further by also accounting for any interest payments the company made during the period. It’s calculated by dividing a company’s earnings before taxes (EBT) by revenue for the period, and then multiplying that number by 100: 

Pretax Margin Ratio = (EBT/Revenue) X 100 

Because the pretax margin ratio accounts for interest payments, it can help investors evaluate a business’s reliance on debt to finance its operations. It can also be useful in circumstances where changing tax law, rates, credits and write-offs might make a company’s profitability appear erratic from one period to the next.    

4. Net profit margin ratio 

A company’s net profit margin communicates the final profit a company has earned once all expenses—including COGS, operating expenses, interest and taxes—are taken into consideration. It can be calculated by dividing the company’s net income for the period by its revenue and then multiplying that number by 100: 

Net Profit Margin Ratio = (Net Income - Revenue) X 100 

The net profit margin ratio is often considered to be the most important margin ratio that investors use to measure a business’s profitability. A company with a high net profit margin ratio compared to its peers indicates that the company is better able to generate sales and control costs than its competitors. 

5. Cash flow margin ratio 

A company’s cash flow margin ratio shows us the company’s ability to turn sales and revenue into liquid cash, which can then be deployed to cover expenses and purchase inventory and other assets. It’s calculated by dividing a company’s cash flow from operations by its net sales and then multiplying that number by 100: 

Cash Flow Margin Ratio = (Cash Flow From Operations/Net Sales) X 100 

Cash Flow From Operations = (Net Income + Non-Cash Expenses + Change in Working Capital) / Sales 

When a company has a higher cash flow margin ratio compared to its peers, it indicates that the company is better at converting sales into cash—cash that can be used to cover expenses, pay down debt, invest in expansion, or even return to investors in the form of dividends or share repurchases.  

6. Return on assets (ROA) ratio 

The return on assets (ROA) ratio compares a company’s profitability against the total assets (including debt) it holds on its balance sheet to determine how efficiently it is using its assets to generate a profit. This can be calculated by dividing the company’s net income by its total assets and multiplying that number by 100: 

Return on Assets Ratio = (Net Income/Total Assets) X 100 

In comparing two similar companies operating in the same industry, investors may look at their return on assets ratios to determine which generates a profit more efficiently. Similarly, an investor may track a single company’s ROA ratio over time to determine whether a company is becoming more or less efficient. 

7. Return on equity (ROE) ratio 

The return on equity (ROE) ratio measures how efficiently a company uses its shareholders’ equity (total assets minus debt) to generate a profit. It can be calculated by dividing the company’s shareholders’ equity by its net income and multiplying that number by 100: 

Return on Equity Ratio = (Net Income/Shareholders’ Equity) X 100 

A company with a high ROE ratio has demonstrated that it can generate a profit without relying on debt. Investors often consider companies with higher than average return on equity ratios to be less risky investments than companies with lower return on equity ratios. Again, as averages can vary significantly from industry to industry, it’s generally a good idea to use ROE ratios to compare only companies operating in the same industry. 

8. Return on invested capital (ROIC) ratio 

The return on invested capital (ROIC) ratio measures how efficiently a business uses its invested capital to generate a profit for investors. This includes shareholders who own the company’s equity, as well as bondholders who own the company’s debt. You can calculate the ROIC ratio by first subtracting dividend payments from the company’s net income and then dividing that number by the company’s debt plus equity and multiplying by 100: 

Return on Invested Capital Ratio = (Net Income - Dividend Payments) / (Debt + Equity) X 100 

Generally speaking, when a company’s ROIC ratio is higher than its cost of capital, it indicates that the company’s financial health is in good standing. When a company has an ROIC ratio that is lower than its cost of capital, it suggests poor performance and may raise questions on the sustainability of the business.  

Profitability ratios can help inform investment decisions 

Most of the information used to calculate the profitability ratios discussed above can be found in a company’s financial statements—such as their income statement, balance sheet, statement of shareholder equity and cash flow statement—which are typically issued quarterly. 

Of course, being able to tell the difference between a profitability ratio that is good and one that is bad—or just average—is something that takes experience, skill and time. The good news? Your financial advisor can get to know your personal situation and help design an investment plan custom to your needs and goals. They’ll also share strategies for growing and protecting your money to help you reach your financial goals.