Profitability is measured by both income and expenses, and it indicates that a business is able to generate more in revenue than expenses.
We’ll explore the difference between profitability and profit (yes, there is a difference) as well as various ratios and other metrics that can be used to measure profitability for your business.
Overview: What is profitability?
Profitability remains the objective of any business, large or small. Profitability measures the ability of a business to generate more total revenue than total expenses.
While there are numerous metrics that can be used to measure the financial health of a business, profitability is used to measure the overall success of a business. A variety of accounting ratios are typically used to measure and analyze the current and future profitability of a business.
Profitability vs. profit: What's the difference?
While many use the terms profitability and profit interchangeably, they actually indicate two different things about your business.
Profit is a number that reflects the amount of money your business has earned after expenses have been paid, and is always reported as a specific dollar amount.
While metrics like retained earnings are a good indicator of business profit, profitability looks at business performance overall, measuring those profits using a percentage that can help analyze and forecast the success of your business in both the short and long term.
How to determine profitability in your business
The easiest, most accurate way to determine the profitability of your business is by using profitability, or financial ratios, which are designed to measure profitability levels for your business.
Keep in mind that if you operate on limited cash flow, you may also want to calculate your operating cash flow ratio. Here are some profitability ratios that you can calculate for your business:
1. Gross profit margin ratio
Gross profit ratio provides an indicator of how much profit a business is earning while taking necessary costs into consideration. The formula for calculating gross profit is:
(Gross profit ÷ Sales) x 100 = Gross profit margin ratio
For instance, if your business has sales revenue in the amount of $25,000 and cost of goods sold of $15,000, you would calculate gross profit margin ratio like this:
($10,000 ÷ $25,000) x 100 = 40%
The results show that your business currently has a gross profit margin of 40%, meaning that your business is able to keep 40% of its revenue after the cost of goods sold has been subtracted from revenue.
A higher gross profit margin indicates that your business is performing more efficiently, while a lower gross profit margin indicates that your product costs are higher than they should be.
2. Operating profit margin ratio
More inclusive than gross profit margin, your operating profit margin gives you a better idea of your percentage of sales against expenses before interest expense and taxes are factored in.
A higher operating profit margin indicates that your business is in a good position to cover necessary costs, and is better equipped to handle an economic downturn than businesses with a lower operating profit margin.
The formula to calculate operating profit margin is a two-step process. First, you’ll have to calculate your operating profit:
Gross profit – Operating expenses = Operating profit
Using the example above, we already know that our gross profit is $10,000. We’ll say that according to our income statement, our operating expenses were $4,800. To arrive at our operating profit, we’ll do the following calculation:
$10,000 – $4,800 = $5,200
Now that we know our operating income is $5,200, we can calculate our operating profit margin ratio:
(Operating income ÷ Sales) x 100
($5,200 ÷ $25,000) x 100 = 20.8%
The result above indicated that after expenses, you have retained 20.8% of your revenue.
3. Net profit margin
Net profit margin is known as the bottom line. While gross profit margin is a good indicator of product profitability, net profit margin looks at all revenue streams and all costs, including interest expense and taxes. Net profit margin should be calculated on a regular basis in order to get a clearer picture of profitability.
In order to calculate our net profit margin, we first have to calculate net profit. We already know that our operating profit is $5,200, but we also have to subtract interest and tax expenses to arrive at our net profit. We’ll say that our interest expense was $220, while our taxes were $1,110:
Operating profit – (Interest expense + Taxes) = Net profit
$5,200 – ($220 + $1,110) = $3,870
Now that we know our net profit is $3,870, we can calculate our net profit margin ratio:
($3,870 ÷ $25,000) x 100 = 15.48%
The result of the calculation above indicates that after all income and expenses have been taken into account, your business is able to retain 15.48% of its total revenue.
4. Return on assets ratio
The return on assets ratio measures how much profit a business can generate from its assets. The calculation for the return on assets ratio is:
Net income ÷ Average total assets
In order to determine your average total assets, you can run a balance sheet for the beginning of the accounting period and the end of the accounting period.
For example, if you’re calculating a return on assets ratio for the year 2019, you would run a balance sheet for January 1, 2019 and December 31, 2019, taking the asset balance from each. You want to be sure to include all assets in your calculation.
For example, if your beginning asset total on January 1 was $215,000, and the ending asset balance was $290,000 on December 31, you can calculate your average asset total as follows:
($215,000 + $290,000) ÷ 2 = $252,500
You would then take your net income from your income statement and divide it by your average total assets in order to arrive at your return on assets ratio. Let’s say that your net income for the year was $35,000:
($35,000 ÷ $252,500) x 100 = 13.86%
This means that for every dollar of assets you had in 2019, you earned almost $0.14 in profits.
While there are other ratios, like the profitability index ratio that can be used to determine the value provided by a particular asset or investment, the return on assets ratio provides a better overall view of asset value.
5. Return on equity ratio
The final profitability ratio we’ll look at is the return on equity ratio. The return on equity ratio is highly valued by investors and potential investors, as it measures the ability of a business to turn investments into profits.
Calculated much like the return on assets, the return on equity looks at beginning and ending shareholders’ equity amounts on the balance sheet. The formula for calculating return on equity ratio is:
Annual net income ÷ Shareholders’ equity = Return on equity
For example, at the beginning of 2019, shareholders equity was $120,000, while at the end of 2019, it was $171,000, with net income for the year totaling $45,000. First, we'll need to find the average shareholders' equity for the year:
($120,000 + $171,000) ÷ 2 = $145,500
Then you can finish calculating the return on equity ratio:
$45,000 + $145,500 = .31%
This means that the company has earned $0.31 of net income for every dollar invested by shareholders.
Profitability should be measured regularly
The best way to measure the profitability (not the profit) of your business is to calculate profitability ratios on a regular basis. Financial ratio analysis provides you with the opportunity to compare results over several periods, giving you a much better idea of overall job performance.
It’s also important to compare results to other businesses within your industry, rather than across the board, as a good profitability ratio for a restaurant is very different from that of a shoe store.
Accurate financial statements are a key component of calculating profitability ratios. Of course, one of the best accounting tools you can use to create accurate financial statements is accounting software, so be sure to check out The Blueprint’s accounting software reviews.