What is a profitability ratio?
Profitability ratios are a set of financial metrics used in accounting[i] to determine a business’s ability to generate profit (earnings) relative to its sales, operating costs, assets reported on the balance sheet, and shareholders’ equity.
These financial measures are some of the ratios most frequently used in accounting. And rightly so, because generating profit is an essential part of a business’s existence.
Generally, profitability ratios are used to measure how profitable a business is in one accounting period over another accounting period such as a financial year, quarter, or month. They are most useful when compared with the profitability ratios of other businesses of the same nature and competitors in the same industry.
Types of profitability ratios
Profitability ratios can be classified into two categories: Margin ratios and return ratios.
Margin ratios include the following ratios:
- Gross profit margin
- Operating profit margin/EBIT (earnings before interest and tax) margin
- Net profit margin
- Operating cash flow margin
Return ratios comprise the following ratios:
- Return on assets (ROA) ratio
- Return on equity (ROE) ratio
Gross profit margin
- What the gross profit margin measures
The gross profit margin, also known as the gross profit ratio, measures the gross profit of a business as a percentage of its sales, also referred to as revenue.
Gross profit (GP) is the difference between sales and cost of goods sold (COGS).
Typically, the gross profit margin is the first profitability ratio calculated by a business.
- Formula
Gross profit margin = (Gross profit/Sales) x 100
All the information needed to calculate a business’s gross profit margin can be found on its income statement.
The formula is expressed as a percentage.
- Example of the gross profit margin
Business A reported sales of R20 000, and cost of goods sold (COGS) of R12 000 for Q4 of 2025.
The gross profit margin of business A will be calculated in the following way:
Gross profit = Sales – COGS
= R20 000 – R12 000
= R8 000
Gross profit margin = (Gross profit/Sales) x 100
= (R8 000/R20 000) x 100
= 0.40 x 100
= 40%
The gross profit margin of 40% is the amount of sales revenue that can be used by business A to cover expenses such as operating expenses, fixed costs, depreciation, selling costs, administrative expenses, while also generating net earnings for the business.
The 40% gross profit margin also shows that business A earned 40 cents in profit and spent 60 cents to manufacture goods for every R1 (one rand) in sales.
Basically, the higher the gross profit margin, the better for the business. Contrarily, a low gross profit margin signals a higher cost of goods sold (COGS) for the business.
Operating profit margin
- What the operating profit margin indicates
The operating profit margin is a performance ratio that indicates the percentage of profit a business generates from its operations before interest charges and taxes are subtracted from the profit. The margin is also called the EBIT (earnings before interest and taxes) margin.
In other words, the operating profit margin measures the remaining percentage of revenue after costs of goods sold (COGS) and operating expenses have been deducted from revenue.
Some analysts and investors use alternatives to EBIT to determine a business’s operating profitability, namely:
- EBITA (earnings before interest, taxes, and amortisation), or
- EBITDA (earnings before interest, taxes, depreciation, and amortisation).
The operating profit margin takes the gross profit of a firm and deducts the operating expenses, which may include administrative and selling expenses, commissions, and other miscellaneous costs. Hence, the operating profit indicates how much revenue of a business is left over after it covers both cost of goods sold (COGS) and operating expenses.
The margin is an indication of how effectively a business’s operating expenses are managed by the management.
- Formula
Operating profit margin = (Operating profit/Revenue) x 100
All the financial data needed for the calculation comes from a business’s income statement.
- Example of the operating profit margin
Company BBB reported the following financial figures for the last quarter (Q4) of 2025.
- Sales (revenue): R 1 500 000
- Cost of goods sold (COGS): R 400 000
- Operating expenses: R700 000
BBB’s operating profit margin will be calculated in the following way:
Operating profit = Sales – COGS – operating expenses
= R1 500 000 – R400 000 – R700 000
= R 400 000
Operating profit margin = (Operating profit/Revenue) x 100
= (R400 000/R1 500 000) x 100
= 0.27 x 100
= 27%
The operating profit margin of 27% implies that company BBB spent 27 cents on expenses unrelated to the direct production costs. Put differently, the 27% operating profit margin shows that company BBB generated R0.27 operating profit for every R1 (one rand) of revenue.
Generally, high operating profit margins provide the following advantages for businesses:
- Businesses are more equipped to cover fixed costs and finance charges.
- They are more protected against economic recessions.
- They are able to offer lower prices to customers than their competitors that have less favourable profit margins.
Net profit margin
- What the net profit margin shows
The net profit (NP) margin, also known as the profit margin or net profit ratio, shows the profit a business generates from its sales revenue after all expenses, including interest and taxes, have been taken into consideration.
Quickbooks describes the net profit margin of a business as the ‘big-picture view.’ The ratio takes all the revenue and expenses into account. However, a disadvantage of the NP margin is that once-off expenses or income make it more difficult to compare a business’s performance with its competitors.
It is the most often used profit margin.
- Formula
Net profit margin = (Net profit after tax/Revenue) x 100
The margin is expressed as a percentage.
Net profit is also known as net income and revenue is also referred to as sales.
The information for the calculation is reported on a business’s income statement.
- Example of the net profit margin
Company ABC is an online business that sells books. ABC’s revenue from book sales was R1 000 000 in 2025 and its reported net profit for the same period was R250 000.
The company’s net profit margin will be calculated as follows:
(R250 000/R1 000 000) x 100
= 0.25 x 100
= 25%
ABC’s net profit margin of 25% means that 25 cents of every R1 (one rand) of sales made are profit. Put another way, the margin indicates how much of every sales South African rand (ZAR) remains as net profit after all expenses, operating and non-operating, are paid.
Operating cash flow (OCF) margin
- What the operating cash (OCF) flow margin expresses
The operating cash flow margin, also known as the cash flow margin, is a type of profitability ratio that is used to calculate the amount of cash made from a business’s operating activities as a percentage of net sales in a specific accounting period.
Put differently, the margin determines the ability of a business to convert sales into cash.
Operating cash flow (OCF), also called cash flow from operations, refers to the amount of cash generated by a company’s core business operations, such as selling goods and manufacturing products.
- Formula
Operating cash flow (OCF) margin = (Cash flow from operations/Net sales) x 100
The numerator, cash flow from operations, is obtained from the first section of the statement of cash flows. Net sales are obtained from a business’s income statement.
The margin is also displayed as a percentage.
- Example of the OCF margin
Business XXX generated R600 000 from its normal business operations during its past financial year and reported net sales of R1 000 000.
XXX’s OCF margin will look as follows:
(R600 000/R1 000 000) x 100
= 0.60 x 100
= 60%
Business XXX’s OCF margin indicates that it is able to generate a sufficient positive cash flow to maintain and expand its normal business operations. Conversely, if the OCF margin shows a negative number, it is an indication that the business is losing money even as it is generating revenue from sales, which means it requires external financing to continue operations.
Return on assets (ROA) ratio
- What the ROA ratio reflects
The return on assets ratio (ROA) reflects how efficiently a business manages its investment in assets, deploying them to generate sales and profit.
The term ‘return’ in the return on assets ratio refers to net income or net profit – the amount of earnings from sales after all costs, expenses, and taxes have been taken into account.
In addition, the ROA ratio shows the asset intensity of a business, which means the lower the profit per rand (ZAR) of assets, the more a business is considered asset intensive.
- Formula
Return on assets ratio = (Net income/Total assets) x 100
The ratio is displayed as a percentage.
The figures for net income and total assets are respectively available on a company’s income statement and balance sheet.
- Example of the return on assets ratio
Company Feel Good reported a net income of R3 000 000 for the financial year ended 31 December 2025 and all its assets amounted to R10 000 000 on December 31, 2025.
Feel Good’s ROA ratio will be calculated in the following way:
(R3 000 000/R10 000 000) x 100
= 0.43 x 100
= 30%
Company Feel Good’s ROA ratio of 30% means that it generates 30 cents for every rand (ZAR) the company keeps in assets.
The higher the percentage of the ratio, the more an indication that the company efficiently utilises its assets to generate profit.
Return on equity (ROE) ratio
- What the ROE ratio measures
The return on equity (ROE) ratio is a profitability ratio that measures a company’s ability to provide a return on the investment of its shareholders.
The ROE ratio is particularly important for shareholders of public-held companies. Potential investors are also interested in the ROE ratio of a company when contemplating whether or not to invest in the company.
Usually, companies with a high return on equity are more competent to generate cash internally, depending not as much on debt financing. Contrarily, a low ROE ratio may signal that management is unsuccessful to effectively use shareholders’ funds to generate a favourable return.
- Formula
Return on equity ratio = (Net income/Shareholders’ equity) x 100
This ratio is also indicated as a percentage.
Data for net income is available on the income sheet and the balance sheet provides the data for the shareholders’ equity.
- Example of the ROE ratio
Company CCC net income for the past financial year is R400 000 and its shareholders’ equity R1 000 000 at the end of the financial year.
Using the formula above, CCC’s ROE ratio will be as follows:
(R400 000/R1 000 000) x 100
= 0.40 x 100
= 40%
The ROE ratio of 40% implies that company CCC made R0.40 profit for each rand (ZAR) from its shareholders’ equity.
In closing
By evaluating profitability ratios and using them in a SWOT-analysis, a business can compare itself against similar businesses and competitors, discovering and understanding its strengths, weaknesses, opportunities, and threats, and act accordingly.
[i] Refer to the article, ‘Accounting Ratios Explained for Dummies’, for an overview of the numerous ratios used in accounting.
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