Profitability ratios are arguably the most frequently used metrics in assessing business performance.
To understand how to improve the results next time, we will use profitability ratios, which can be divided into two groups: margin ratios and return ratios.
This article focuses on margin ratios: how well a business can translate revenue into profits.
We’ll have a look at the four levels of profit margin:
- Gross profit margin
- EBITDA margin
- Operating profit margin
- Net profit margin
Each ratio compares revenue with different types of expenses. For this reason, I suggest tracking them all together so that you can assess profitability from different angles. Also, include them in your financial model.
And you can calculate ratios over any given time, for example, a month or a year. Just make sure to choose the same period for all components that make up the ratio.
Without further ado, grab an income statement and let’s dive in.
Table of contents
Gross profit margin
The gross profit margin shows the share of revenue the business retains after taking into account the direct costs of producing goods or services. We don’t subtract any other expenses other than the cost of sales (or cost of goods sold).
How to calculate:
Gross profit = Revenue – Cost of sales
Gross profit margin = Gross Profit / Revenue * 100%
Remember to use net revenue, which is revenue after discounts and returns (this also applies to other ratios below).
Let’s take an ice cream shop an an example. Last month, the shop generated $10,000 in revenue. The ice cream was purchased from a local supplier for $5,000. Hence, the gross profit is $10,000 – $5,000 (cost of sales) = $5,000, and the gross profit margin is $5,000 / $10,000 * 100% = 50%.
You may be wondering, what is a good gross profit margin? I wish there was a magic number, but it very much depends on the industry. For instance, a reasonable ratio for an agriculture company could be 10%, while for a SaaS business, 60% is considered low.
A good starting point would be to benchmark with direct competitors if you can get access to their financial statements.
More important, though, is to keep an eye on the development over time. I wouldn’t expect gross profit to fluctuate much month-over-month in a stable business environment.
EBITDA margin
EBITDA stands for Earnings Before Interest, Taxes, Depreciation, and Amortisation. It’s a useful measure because it focuses on operating performance, ignoring the effects of accounting policies, financing decisions, and tax strategy, which we can’t influence in the short term anyway.
Investors often use EBITDA to compare profitability between different industries and companies.
To calculate the EBITDA margin, we subtract the cost of sales and operating expenses like rent, utilities, marketing, and administrative salaries from revenue. However, we do not deduct depreciation and amortisation, which are non-cash items.
Let’s call this group of expenses ‘normalised operating expenses’ so we don’t confuse them with the definition of operating expenses presented on the income statement.
How to calculate:
EBITDA = Revenue – Cost of sales – ‘Normalised’ operating expenses
EBITDA margin = EBITDA / Revenue * 100%
Continuing with our example, say the monthly rent of the shop premises is $2,000. We also paid a $1,000 salary to our only employee. Then the EBITDA is $10,000 – $5,000 – $2,000 (rent) – $1,000 (salary) = $2,000, and the EBITDA margin is $2,000 / $10,000 * 100% = 20%.
Operating profit margin
The operating profit margin, also known as EBIT (Earnings Before Interest and Tax) margin, measures profitability by expressing operating profit as a percentage of revenue.
To arrive at the operating profit, we have to subtract all operating expenses — including depreciation and amortisation. In most cases, the result will be similar to EBITDA unless the business has substantial long-term assets or liabilities.
How to calculate:
Operating profit = Revenue – Cost of sales – Operating expenses
Operating profit margin = Operating profit / Revenue * 100%
To continue the illustration, the ice cream is stored in a freezer (a long-term asset). The monthly depreciation of the freezer is $500. Therefore, the operating profit is $10,000 – $5,000 – $2,000 – $1,000 – $500 (depreciation) = $1,500, and the operating profit margin is $1,500 / $10,000 * 100% = 15%.
Net profit margin
Finally, the net profit — or the bottom line — is simply the profit we’re left with after paying all expenses, including interest and tax.
As with the other ratios, the net profit margin is expressed as a percentage of revenue. It indicates how effective the business model is at generating profits overall.
How to calculate:
Net profit = Revenue – Cost of sales – Operating expenses – Interest – Tax
Net profit margin = Net profit / Revenue * 100%
Like with the gross profit margin, it’s difficult to come up with a specific target for the net profit margin, and it varies from industry to industry. Nonetheless, regularly monitor the ratio to see how well you’re managing the costs.
To conclude our example, suppose the monthly allocated income tax is $500. And luckily, we don’t have any loans, thus no interest payments. The net profit is $10,000 – $5,000 – $2,000 – $1,000 – $500 – $500 (income tax) = $1,000, and the net profit margin is $1,000 / $10,000 * 100% = 10%.
Final thoughts
Hopefully, now you have a better picture of how to calculate different profit margins.
However, the real key is to be proactive and act on the analysis.
There is no doubt profitability depends on many factors. That said, regularly reviewing the margin ratios can help you identify the low-hanging fruits on both the revenue and cost sides and make improvements.
Such as changing that ice cream supplier.
