Profitability ratios assess a company’s ability to generate profits from its assets and operations, comparing various P&L statement categories to evaluate its return on investment.
Primary Implication
Every business on every transaction either earns a profit or they don’t. The cumulative results of each sales transaction by month, quarter, or year are reported on the P&L Statement representing Gross Sales. Subtract the direct, indirect, and nonoperating costs from Net Sales, and you get the Net Income or Net Profit for that period.
If a business struggles to earn profits, the Profitability Ratios are simple calculations to quickly assess where the business is losing money generating Net Sales.
Overview
Is Your Business Truly Profitable? Find Out Now
Understanding your business’s profitability is crucial to its success. Profitability ratios help you measure how effectively your company uses its resources to make money. They can also give you a good indication of your company’s financial health.
What are Profitability Ratios?
Profitability ratios compare different values on your Profit and Loss (P&L) Statement to show how well your company generates profits. Think of it like this: every dollar you spend in your business is an investment. Profitability ratios help you track the return on that investment.
Most Common Profitability Ratios:
- Gross Margin: Shows the profit earned on your sales after deducting the cost of goods sold.
- Operating Margin: Measures your profit after deducting operating expenses like rent and salaries.
- Net Income Margin: Your overall profit margin after all expenses are paid.
- Return on Assets (ROA): Indicates how effectively your company uses its assets to generate profit.
- Return on Equity (ROE): Measures how much profit your company generates for its shareholders.
Why are Profitability Ratios Important?
- Measure your financial health: Profitability ratios can help you identify areas where your business is performing well and areas where you need to improve.
- Track your progress over time: By comparing your ratios over time, you can see if your profitability is improving or declining.
- Make informed business decisions: Profitability ratios can help you make informed decisions about pricing, expenses, and investments.
The failure to manage your business to earn profits means you will never have acceptable cash reserves in the bank. You protect this from happening by earning profits that allow you to build sustainable cash reserves.