Profitability ratios are a collection of financial metrics used to evaluate a company’s ability to turn a profit in relation to its revenue, equity, assets, and other financial elements. These measurements are effective diagnostic tools that can provide insightful financial analysis and strategic advisory guidance, allowing businesses to make more informed decisions.
According to Investopedia, these metrics are divided into two primary categories: margin ratios and return ratios. This KPI glossary entry will explore the essential ratios in both groups and how they influence business strategy.
These metrics show many aspects of a company's performance, and each measurement offers unique insights into financial and operational management, such as:
The two primary types are margin ratios (which calculate profit in relation to sales) and return ratios (which calculate profit in relation to capital invested). Each ratio provides a unique perspective for analysing an organisation's financial performance.
Margin ratios highlight cost and pricing effectiveness by calculating a company's profit from revenue at different income statement levels.
Return ratios help stakeholders evaluate a company's financial efficiency by measuring how well it uses its capital (such as equity, assets, or total investments) to generate profit.
Each of these ratios offers a distinct viewpoint on how effectively a company makes profit, whether through core operations, cost control, or overall resource utilisation.
Fundamentally, they all assess how well a company converts its inputs into profits by comparing a profit figure to a financial reference point, typically revenue, assets, or equity.
General formula: Profitability ratio = Profit measure / Reference metric
Below are some of the most critical formulas to know:
The gross margin ratio calculates the percentage of revenue left over after subtracting the direct production costs (cost of sales or COS), to assess how effectively a business delivers its goods or services.
Formula: Gross margin = (Revenue – Cost of sales) / Revenue × 100
In sectors with tight cost control and pricing pressure, this ratio is particularly significant. While an increasing gross margin might indicate better supplier terms or increased production efficiency, a declining margin could suggest rising input costs or underpricing.
EBIT margin measures the percentage of revenue remaining after all operating costs, like overheads, payroll, and depreciation, have been paid (but before interests and taxes).
Formula: EBIT margin = EBIT / Revenue × 100
Where: EBIT = Revenue – COS – Operating expenses
Regardless of financing and tax strategies, this ratio demonstrates the performance of a firm's core operations. It helps compare operating models among peers, assess internal efficiency, and find areas for cost savings.
EBITDA shows a more accurate estimate of operational cash flow relative to revenue, as it removes non-cash expenses like depreciation and amortisation.
Formula: EBITDA margin = EBITDA / Revenue × 100
Where: EBITDA = EBIT + Depreciation + Amortisation
This is particularly useful in capital-intensive industries, where depreciation can distort profitability. It is also used to standardise financials across businesses with different asset bases or accounting practices.
The ratio displays the portion of revenue that remains as net profit, following the deduction of all costs, such as interest, taxes, operating expenses, and one-off items.
Formula: Net profit margin = Net income / Revenue × 100
Where: Net income = Revenue – All expenses
This is the most thorough indicator of profitability, showing how effectively a company converts sales into overall profits.
However, since non-operational factors like tax strategies, interest rates, and extraordinary items can affect this ratio, it should be interpreted carefully.
For a full grasp of profitability trends and drivers, the following factors should be taken into account:
To see how these calculations work in practical application, consider a mid-sized manufacturing company and its financial data for the fiscal year ending in 2025:
These ratios can help stakeholders understand whether the company is profitable and whether there is room for margin growth.
True financial clarity comes from blending these ratios with deeper modelling techniques and complementary tools. This is why it matters to consider:
While understanding margin ratios provides important information, context is what gives metrics meaning. To properly interpret them, here are some things to consider:
In business management, these ratios have several useful applications, such as:
These profit metrics are crucial for everyone with a financial stake in a business. They offer clarity and are the cornerstone of financial performance communication, especially in:
You need more than just basic financial ratios to fully comprehend how a business makes money and how to increase it. Beyond the fundamentals, Fathom's dedicated profitability analysis tool offers powerful visual insights into a business's cost structure and profit margins.
Through Fathom’s profitability tool, you gain a more strategic understanding of your client's financial health, empowering you to make smarter, sharper, and more confident decisions.
Profitability ratios are highly valued by all stakeholder groups. For accountants, financial advisors or even business managers, these performance indicators can illuminate the real drivers of operations and provide clear and confident guidance on pricing, cost control, and investment choices.
In the end, these ratios can improve financial narratives, encourage meaningful dialogue with fellow stakeholders, and help any company achieve greater success.
Net profit margin, operating profit margin, gross profit margin, return on assets (ROA), and return on equity (ROE) are often the most important ratios. These ratios offer a thorough view of a business's capacity to manage expenses, generate revenue, and deliver returns to shareholders.
The best way to gauge a company's profitability is to use both return and margin ratios. Return ratios evaluate how well resources are used to produce returns, while margin ratios show how much profit is made from revenue.
A "good" profitability ratio depends on the context, as it should be evaluated against competitors, industry standards and the company’s past performance. For instance, a 10% net profit margin might be good for a retail business but could be considered low for a SaaS company.
The business is in good health if your ratios show consistency or growth over time, align with industry averages, and demonstrate that the firm can comfortably cover costs while generating steady returns.
Profitability ratios measure a company’s ability to turn revenue, assets, or equity into profit. They offer insight into whether a company produces sustainable returns, which supports short-term operational reviews and long-term financial planning.
Hamidah Abd Rahman is a content writer at The Access Group and Fathom. With a strong focus on B2B industries, she has written content across sectors such as data science, supply chain, aviation, and ERP.
