What are the three main profitability ratios and how do you calculate them?

Revolut Contributor

 · June 29, 2020  · 06/29/2020

Profitability ratios are metrics that reveal insights about the financial health of a business. Each ratio measures performance relative to a specific variable, such as its revenue, over a given period. The results highlight how successful the business is at using its assets to make profits, to deliver value to shareholders, or to create cash to pay its bills.

How do you calculate profitability ratios?

Every financial ratio has a unique profit formula, and we cover the most popular ones below. There are dozens in total, yet they loosely fit into three headings:

  • Margin ratios (i.e. ability to generate types of profit as a proportion of revenue)
  • Return ratios (i.e. ability to create different kinds of returns for shareholders)
  • Cash flow ratios (i.e. ability to convert revenue into cash or create a surplus)

It’s wise to keep a close eye on profit ratios by including them in monthly management accounts. As with all ratios, you would typically express the result as a percentage – and then track the result against the same metric from earlier periods, a forecast, or an industry benchmark.

Let’s talk about… margin ratios

These ratios show how well the business converts revenue into profit. You define profitability as the extent to which a business has funds remaining after it deducts costs from revenue. Of course, there are different flavours of profit, depending on which categories of costs the business includes in the calculation. Each profit figure is easily converted into its associated margin (i.e. ratio) if you divide this monetary value by its revenue over the same period.

The three most common ratios of this type are the net profit margin, operating profit margin and the EBITDA margin.

Net Profit Margin

The net profit calculation removes the total costs of the business. In general, that includes any interest and tax it owes too but there is some ambiguity over the tax point within the UK. This margin is a simple idea to grasp, yet its comprehensive nature can make it a blunt instrument compared to rival metrics.

Net profit margin = Net profit / Revenue x 100

Learn more about net profit margin and how is it calculated.

Operating profit margin

The operating profit is the business revenue, minus its day-to-day running costs, which is sometimes called the operating expenses. This calculation does not include any interest nor tax that the business owes, so a simple way to describe this is to add these elements back onto the net profit figure. You then convert that result into the operating profit margin.

Operating profit margin = (Net profit + Interest + Tax) / Revenue x 100

Unlike the net profit margin, this ratio is focused on the core costs of the business because interest and tax costs are less relevant to everyday operations. It’s often described as EBIT, as these two metrics are so similar but they do have subtle distinctions outlined here.

Learn more about operating profit margin and how is it calculated.

EBITDA margin

The EBITDA margin ratio goes one stage further than the operating profit margin ratio. In addition to ignoring interest or tax that the business owes, the calculation also doesn’t include depreciation and amortisation costs. These are the allowances made in the accounts of a business for the falling value of any long-term assets that it owns.

EBITDA margin ratio = (Net profit + Interest + Tax + Depreciation + Amortisation) / Revenue x 100

The EBITDA margin ratio is useful because it strips-out these two technical costs, which are not directly related to how efficiently the business generates cash. More detail about EBITDA here.

Let’s talk about… Return Ratios

Return ratios reveal how well a business generates returns for shareholders. Unlike margin ratios, these ratios are calculated using elements of the balance sheet of the business as well as its profit and loss account, which is another way to describe the income statement.

This type of ratio shows how good the business is at converting investment – which could be assets, equity or debt – into profits. The higher the ratio value, the greater the profitability of the business per pound that it has borrowed, received as investment, or spent on assets.

The most useful return ratios for SMEs are the return on capital employed (ROCE), the return on equity (RoE) and the return on assets (RoA).

Return on capital employed (ROCE)

This ratio is a reliable indicator of how well a business uses its resources. You calculate this figure by dividing the operating profit by capital employed. Capital employed is the sum of the main elements on a balance sheet: share capital, retained earnings and long-term debt.

Return on capital employed ratio = (Operating profit / Capital employed) x100

The higher this percentage, the more effective a business is at converting its capital to profit. There are two ways to boost ROCE: increase its operating profit or reduce capital employed.

Learn more about ROCE.

Return on equity (RoE)

The return on equity profitability ratio tends to be calculated alongside the return on capital employed as it expresses the profit per pound invested into the business by shareholders.

It’s a great way to gauge how well the business is managing its investment.

Return on equity = (Net profit / Shareholder equity) x 100

Learn more about ROE.

Return on assets (RoA)

This ratio is useful to businesses which spend significant amounts of money on assets, such as those in the manufacturing or telecoms sectors. A higher return on assets percentage indicates the business is using its assets efficiently to generate profits relative to this cost.

Return on assets = (Net profit / Total assets) x 100

Let’s talk about… cash flow ratios

These show how well a business converts sales into cash and indicate in relative terms if it is building a cash surplus or a deficit. They are vital because a business can be profitable yet slow to collect payment of its invoices. Running out of cash is a common reason why a business fails. The most popular ratios of this type are the cash flow margin and net cash flow.

Cash flow margin ratio

This ratio shows the profitability of a business purely in the context of cash movement over a given period. Like other cash flow ratios, it should be part of monthly management accounts.

The calculation takes the net profit figure and adds back non-cash accounting entries, such as depreciation or amortisation, as well as any changes in working capital (i.e. the monthly movement between debtors, trade payables and stock). You then divide this result by total revenue to see how effectively the business converts its sales (i.e. revenue) into cash.

Cash flow margin = (Net profit + Non-cash expenses + Changes in working capital) / Revenue) x100

Net cash flow

The net cash flow ratio reveals the percentage by which the business is running either a cash deficit or a surplus. A negative result here indicates that the business might require external financing, while a high surplus percentage means it is unlikely to run out of cash.

In this simple calculation, you take the total value of cash inflows (i.e. revenue) and deduct the cash outflows (i.e. direct costs and indirect costs). You then divide the resulting deficit or surplus by whichever is the larger of the cash inflows or outflows figures. That’s it.

Net cash flow margin = (Cash inflows – Cash outflows) / (Larger of cash inflow OR outflow figure) x 100

Let’s look at an example. Avocado Ltd is a fictional firm that makes and sells fruit-shaped furniture in London. During April, it reports £40k in cash inflows and £30k of cash outflows.

Net cash flow margin = (£40k – £30k) / £40k x 100 = 25%

By now, you will surely appreciate the potent insights profitability ratios provide. The secret to gaining the most value from them is to understand the benefits and limitations of each one. As with all metrics, it’s wise to monitor several of them each month – there is rarely one silver bullet – so that the business can spot patterns over time and take appropriate action.

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