Upon receiving a clinical exam, the patient is confronted with a series of unfamiliar terms. They don’t know what the numbers of their cholesterol or blood sugar mean, for example. Likewise, many entrepreneurs do not devote themselves to understanding their profitability ratios and what they say about the health of the company.

Now imagine that this patient decided not to show their exams to the doctor. In doing so, they ignored the results and will not be able to make decisions about their health, becoming completely vulnerable.

This mistake is also made by many companies that choose not to keep up with the main profitability ratios of their business. Now, if you want to know what these indicators are, what they are for, and which ones are the most important measures of your company, keep reading!

**Understand what profitability ratios are**

In any enterprise, many things can be measured in numbers. No matter the area of operation or the size of the organization, it is always possible to know, more or less roughly, what is happening to the business through metrics.

The entrepreneur may want to know, for example, how much they sold in a certain period, how much their total inventory costs are, or how large their debt to creditors is. These are all values that, when related, present different profitability ratios.

The importance of profitability ratios lies in the fact that they are the most reliable indicators of the behavior of a company. Because they are based on quantitative data, an investor is much more confident in their decisions. After all, an entrepreneur may be charismatic, but it is the return on investment that will prove management competence.

**Understand what profitability ratios are**

In any enterprise, many things can be measured in numbers. No matter the area of operation or the size of the organization, it is always possible to know, more or less roughly, what is happening to the business through metrics.

The entrepreneur may want to know, for example, how much they sold in a certain period, how much their total inventory costs are, or how large their debt to creditors is. These are all values that, when related, present different profitability ratios.

The importance of profitability ratios lies in the fact that they are the most reliable indicators of the behavior of a company. Because they are based on quantitative data, an investor is much more confident in their decisions. After all, an entrepreneur may be charismatic, but it is the return on investment that will prove management competence.

**Learn about the 6 main profitability ratios**

**1. Margin index**

This index is very important for entrepreneurs and for those who want to invest. Imagine that your company wants to attract investors to expand its area of operation. The problem is that your direct competitor wants the same thing.

In this example, the investor will analyze which company is able to bring in more profits, and for that, they will look at the net and gross margin indexes of the companies.

To calculate the gross margin, the following calculation should be made:

Gross Margin = Gross Profit / Net Revenue

In this case, the investor will discover how much the company earned before paying its taxes, labor charges, etc.

The net margin, in turn, takes into account all these burdens. The calculation is as follows:

Net Margin = Net Income / Net Revenue

The higher the margin, the better the investment, because it means that the company profits more from invested capital.

**2. EBITDA**

EBITDA is an acronym in English that means Earnings before Interest, Taxes, Depreciation and Amortization. This is why it is one of the most used profitability ratios, as it shows the operating profit of the company, revealing its cash flow potential.

Some entrepreneurs may ask themselves: “Why analyze an indicator that excludes so many factors that burden the company? Are these factors not part of the business?”

The negative result of a company can be caused by financial errors, such as contracting a loan, for example. In this case, the entrepreneur who has a positive EBITDA but a negative profit knows that the business itself is on the right track. They should do a financial study or a review of indebtedness, for example.

**3. Return on equity**

This is the result of the **net income divided by shareholders’ equity**. Although it is a simple calculation, this is one of the profitability ratios that cannot be ignored.

Over time, a stable return on equity may indicate stagnation. But if this stable margin is accompanied by an increasing shareholders’ equity and net income, it is a good sign for the company; after all, it shows that it is reinvesting capital and seeking improvement in its performance.

**4. Return on asset**

This index shows how much the company’s total assets are bringing as a return for each dollar invested. This is the well-known ROI (Return over Investment).

The formula for calculating this index is as follows:

Return on Asset = (Net Income/Total Assets) x 100

Thus, the higher the percentage, the higher is the profitability of the asset in a given period. Their values, if compared over various periods, may indicate business acceleration or deceleration.

**5. Total debt ratio**

Some companies incur more debt than others. This is because each company operates differently, and for some businesses it is convenient, for example, to rent rather than buy. Therefore, in debt management, the debt ratio reflects an extremely important data in the operation of a company.

Through this indicator, it is possible to know if the company is at risk of major impacts on its cash flow, which can trigger problems for the business. Therefore, it is important to analyze a company through this index along with others, and to ensure a company’s debt security limits.

To calculate the total debt of a business, the formula is as follows:

Total debt = (Third party capital/Total assets) x 100

Thus, this formula indicates how much of the asset value comes from costs with third party capital, such as space rentals or technologies.

**6. Price/profit ratio**

This index is especially relevant when it comes to getting investors for the business, as it may reflect the market interest in betting on the company’s product or service.

Among market value indices, price on profit is the best known and also the simplest, as it demonstrates an investor’s direct expectation of the asset in question. Basically, the price/profit ratio shows how much an investor is willing to pay for each profit earned.

The formula for calculating this index is as follows:

Price/profit ratio = Asset price/Asset profit

Thus, the entrepreneur knows how much an investor can expect as a return from a partnership, articulating good proposals for a negotiation.

As we have seen in this article, it is very important to understand the profitability ratios of a company. It is also worth remembering that these references depend on the sector and activity processes of a company. Therefore, care must be taken when comparing ratios between companies.

Did you enjoy learning more about profitability ratios? How about complementing your reading and learning how to reduce your business costs without losing quality? Download our e-Book and find out!