If you're looking to grow your business, you need to understand profitability ratios. These ratios help you measure how efficiently your business is using its assets and generating revenue. There are three main types of profitability ratios: operating, asset use, and contribution. In this blog post, we'll discuss what each one is and how to use them to make smart decisions for your business
What is a Profitability Ratio?
A profitability ratio measures how efficiently your business is using its assets and generating revenue. Profitability ratios are used by lenders, investors and profit-seeking businesses to evaluate a company's ability to generate profit relative to sales, assets or equity.
Profitability ratios can be calculated on an annual basis or over any time period you choose. For example, if you're evaluating your company's profitability ratio based on the sales of widgets in a specific month, you could calculate each ratio using that time period.
Operating Profitability Ratio
The operating profitability ratio measures how much profit your business generates from its operations compared to the revenue it earns. To understand this better, let's look at an example.
Let's say you own a company called Widget Co., which manufactures widgets and sells them to retailers for $100 each. In one month, your business produced 100,000 widgets and sold 70,000 of them at $100 each. The operating profitability ratio would be calculated as follows:
First, we calculate the gross profit by subtracting the cost of goods sold from the revenue. This gives us $700,000 (70,000 x $100 - 100,000 x $60).
Next, we divide the gross profit by the revenue to get the operating profitability ratio. This gives us 0.70 (700,000 / 1000000).
This tells us that for every dollar in revenue Widget Co. generates, it earns 70 cents in gross profit.
Asset Use Profitability Ratio
The asset use profitability ratio measures how much profit your business makes from the use of its assets, minus the cost of those assets. This ratio is helpful for businesses that have a lot of fixed assets, such as property and equipment.
Let's use the same example as above to calculate asset use profitability ratio. In this scenario, Widget Co.'s fixed assets are worth $200,000 and its total revenue is $100,000 (70,000 units sold at $100 each). We'll also assume that the company has no debt or other liabilities.
First, we calculate the net profit by subtracting all expenses from revenue. This gives us $300,000 (100,000 x 100 - 70,000 x 60).
Next, we divide the net profit by fixed assets to get the asset use profitability ratio. This gives us 0.15 ($300,000 / 2000000).
This tells us that for every dollar in fixed assets Widget Co. owns, it earns 15 cents in net profit.
Contribution Profitability Ratio
The contribution profitability ratio measures how much money your business makes from each
sale after deducting variable expenses such as material costs and labor. It's also known as the gross margin percentage because it’s calculated by dividing the gross margin by sales.
Let's use the same example as above, but this time we'll assume that Widget Co. has a contribution margin of $40 per widget (meaning it costs the company $60 to produce each widget, but it sells them for $100).
First, we calculate the gross margin by subtracting the cost of goods sold from the revenue. This gives us $600,000 (100,000 x $100 - 100,000 x $60).
Next, we divide the gross margin by sales to get the contribution profitability ratio. This gives us 0.60 (600,000 / 1000000).
This tells us that for every dollar in sales Widget Co. generates, it earns 60 cents in gross profit.
This figure can help you to understand how effective your marketing efforts are and whether you're pricing your products correctly.
How to Use Profitability Ratios
Profitability ratios are helpful when used alongside other financial metrics because they can help you make sense of your business's overall profitability and identify areas where you can improve performance. For example, if your company’s asset use profitability ratio is low, you might consider investing in more fixed assets to increase profits.
Likewise, if your contribution profitability ratio is high, you might be able to reduce the cost of goods sold by finding a cheaper supplier or streamlining production.
Final Thoughts
Keeping track of your company's profitability ratios can help you make informed decisions about how to improve profitability, reduce expenses and grow your business. A more profitable company is better positioned to earn more revenue, hire new employees, and reinvest in itself.
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