What is Profitability Ratio?
A Profitability Ratio compares a profit measure to revenue to determine the remaining profits after certain types of expenses are deducted.
Profitability ratios are standardized against revenue—i.e. expressed as a percentage of revenue, allowing for comparisons between companies.
How to Calculate Profitability Ratio (Step-by-Step)
A profitability ratio divides a profit metric by the amount of revenue generated in the corresponding time period, which is insightful in terms of understanding a company’s historical spending trends.
For instance, most of a company’s spending could be related to cost of goods sold (COGS), operating expenses (OpEx), or non-operating items.
In practice, multiple profitability ratios should be used in conjunction with each other to measure a company’s true financial state and to develop a comprehensive understanding of its cost structure and business model.
The reliance on only one profit metric can lead to misguided interpretations, especially in the absence of a firm grasp of relevant industry-specific considerations.
Profitability Ratio Formula
Formulaically, the structure of a profitability ratio consists of a profit metric divided by revenue.
The resulting figure must then be multiplied by 100 to convert the ratio into percentage form.
Once standardized, the ratio can subsequently be used for purposes of comparability, either to the company’s own historical performance or against its closest industry peers.
Gross Margin Ratio Formula — Gross Profit to Revenue
The gross margin ratio compares a company’s gross profit to its revenue.
Since the gross profit metric deducts only one expense—the company’s cost of goods sold (COGS)—the gross margin ratio reflects the percentage of revenue left over after the direct operating costs have been taken into account.
The cost of goods sold (COGS) line item is found right below revenue (or sales) on the income statement, and represents the direct costs incurred by a company to generate revenue, e.g. direct materials and direct labor costs.
EBIT Margin Ratio Formula — Operating Income to Revenue
The EBIT margin ratio, or “operating profit margin”, compares a company’s operating income to its revenue.
Operating income (EBIT) is a GAAP measure of profitability calculated by subtracting operating expenses like SG&A and R&D from gross profit.
Like COGS, operating expenses are also part of the core operations of a company, i.e. the costs that must be incurred for the company to continue operating.
However, the distinction is that operating expenses are not directly related to a company’s process of revenue generation.
Therefore, the EBIT margin ratio represents the percentage of profits remaining once both direct and indirect operating costs—COGS and OpEx—have been deducted from revenue.
EBITDA Margin Ratio Formula — EBITDA to Revenue
The EBITDA margin ratio compares a company’s EBITDA to its revenue in the corresponding period.
Unlike EBIT, EBITDA is a non-GAAP measure of profitability, so the metric is not typically found on the income statement.
Still, EBITDA is by far the most widely used measure of profitability and is calculated by adding depreciation and amortization (D&A) to EBIT.
Depreciation and amortization expense are non-cash items, meaning there is no real movement of cash associated with these line items.
Instead, these non-cash expenses are recognized on the income statement to abide by accrual accounting reporting standards.
- Depreciation → The allocation of the purchase cost of fixed assets (PP&E) over the expected useful life of the long-term asset, i.e. the capital expenditure (Capex) is periodically recognized, rather than all at once.
- Amortization → Similar to depreciation, amortization allocates the cost of intangible asset purchases over their useful life assumptions, although not all intangible assets can be amortized.
The EBITDA margin ratio thereby reflects the percentage of revenue remaining once all direct and indirect operating costs have been subtracted, with the additional step of removing the effects of non-cash items, namely D&A.
Because EBITDA is a non-GAAP metric, companies have the option to make additional discretionary adjustments, such as for stock-based compensation (SBC).
Therefore, it is essential to question and analyze each adjustment, as opposed to taking the EBITDA figures as stated by management (or by an equity analyst) at face value.
Net Profit Margin Ratio Formula — Net Income to Revenue
The net profit margin ratio compares a company’s net income to its revenue.
The net income metric (i.e. the “bottom line”) is the revenue left over once all costs, operating and non-operating, are deducted.
In effect, the net profit margin ratio represents the accrual-based profitability of a company after subtracting all costs, including non-operating costs and taxes.