Understand your company’s profitability at multiple levels with three important margin ratios

Profitability ratios are key financial metrics that offer deep insights into how effectively a business converts its resources into profit by comparing its earnings against various aspects such as revenue, costs, assets, or equity.

Businesses use profitability ratios to understand their profitability across geographies, product lines, and sectors. They can also compare across different time periods and against industry benchmarks, to identify areas for improvement and make informed strategic decisions.

In this article, we'll explore how to evaluate the profitability of your business at three different levels using margin ratios: gross profit, operating profit, and net profit. 

Understanding the profitability of your business at three levels with margin ratios 

Businesses profitability ratios to gain insight into their business and answer different types of questions about their financial performance. 

There are two main type of profitability ratios:

• Margin ratios: These ratios are used to evaluate how well a company converts its sales into profit. 
• Return ratios: These ratios are more focused on the company’s ability to generate returns for its investors. 

Here, we’ll focus specifically on margin ratios, which can provide deep and actionable insights into your business. 

Like all profitability ratios, margin ratios are always expressed as percentages. In the simplest sense, they reveal how much of your total revenue remains after all expenses are accounted for.  

With margin ratios, you can examine the relationship between a company's revenue and various levels of profit. This not only gives you a deeper understanding of your financial performance but it can also provide insights into different aspects of your business. Allowing you to assess:  

• Pricing effectiveness: How well is the company pricing its products or services to cover costs and generate profit?
• Cost management: Is your company effectively managing expenses relative to its revenue?
• Operational efficiency: How efficiently does your company turn sales revenue into profit?
• Competitive benchmarking: How does the company's profitability compare to industry peers?

How to do a three-level profitability analysis

Let’s look at how you can use three different margin ratios – gross margin, operating profit margin, and net profit margin – to answer some of the questions above. Note that our use of the word "level" here really just refers to different ways to look at profitability. 

Gross margin 

Gross margin (aka gross profit margin) represents the most fundamental level of profitability analysis. It tells you how much profit the company retains after accounting for the direct costs associated with producing software products, goods or services, also known as the cost of goods sold (COGS).

Calculating gross margin begins with a calculation of your gross profit:  

The gross margin formula below illustrates how gross profit factors into the profitability analysis at this level: 

You’ll notice that at this most basic level of analysis, in terms of expenses, we’re only looking at COGS, which represent the direct costs involved in producing the products and services the company sells. COGS is directly related to the number of customers a company has. More customers mean higher COGS and vice versa. 

Gross margin indicates what percentage of each dollar in revenue it is able to retain after accounting for its COGS. Thus, the higher the gross margin, the more money the company has to cover its operating expenses and invest in growth opportunities.  

The gross profit margin can offer insights into how efficiently you’re using your resources and how well your pricing strategy is working for you.  

Gross margin also provides a basis for comparison with industry benchmarks. Benchmarking their gross margin against similar companies can help leaders determine if they need to look for ways to reduce their COGS. It can also help current investors evaluate the company’s prospects and potential investors decide whether the company is a good bet. 

Operating profit 

Operating profit margin goes a level deeper than a gross margin analysis by revealing how much profit a company generates from its core business operations after accounting for both COGS and operating expenses. 

This is an important metric because it showcases the efficiency of a company in managing its operations and controlling costs beyond just COGS. 

Determining your operating margin begins with a calculation of your operating profit, which includes the gross margin you calculated above:  

The operating profit margin formula below illustrates how operating profit now factors into the profitability analysis at this level: 

A higher operating profit margin indicates that the company is more efficient at converting sales into actual profit. This ratio is particularly useful for comparing companies within the same industry, as it accounts for differences in operational structures.

Because this calculation includes all the three main cost areas of the business – research and developed (R&D), sales and marketing (S&M), and general and administrative (G&A) expenses – company leaders can use this level of profitability analysis to spot specific areas in which optimizing expenses might have the biggest impact. 

Net profit margin

Net profit margin represents the third and most comprehensive level of profitability analysis as it reveals how much profit a company ultimately retains from its total revenue after accounting for all expenses.  

Net profit builds on net income (aka net profit), which already accounts for COGS and operating expenses, and takes into consideration taxes and other non-operating income and expenses (e.g., foreign exchange (FX) gains or losses, interest payments, etc.).

Once you know your net income, you can calculate your net profit margin:

An important point to remember is that while net profit margin offers the most comprehensive view of profitability, it is important to consider it alongside gross profit margin and operating profit margin to get a complete understanding of where value is being created or lost in your business operations. 

Here’s a summary of the key differences between net profit margin versus operating profit margin:

An example profitability analysis

The table below illustrates what a three-level profitability analysis for a small SaaS startup might look like using the formulas provided above. 

Note that you can do any or all of these three levels of analyses for as many years as you want in a single profitability analysis, for example, to see trends over time. 

You can also look at all three types of profitability analyses together to gain additional insight from your analysis. 

In the table below, we can immediately see that our operating expenses (see second-level analysis) are eating away a lot of our profit relative to our COGS (see first-level analysis).  Factoring in taxes plus other income and expenses (see third-level analysis), we find that they're only taking a small bite out of our total profit margin. So, in this example, we might want to take a look at where we can cut or optimize our operating expenses to bring our net profit up.  

How companies can use profitability ratios to understand and improve their business

In our discussion above, we’ve touched on some of the ways that businesses can use margin ratios, specifically gross margin, operating profit margin, and net profit margin, to gain actionable insights into their businesses.

Now, let’s take a broader look at how companies can use the insights profitability ratios provide to better understand and improve their financial health, operational efficiency, and overall performance: 

• Performance evaluation: Profitability ratios allow businesses to assess their financial performance over time. They help identify trends, whether positive or negative, that affect the company's ability to generate profits.
• Competitive analysis: By comparing profitability ratios with industry peers, companies can gauge where they stand. This can help inform strategic decisions to improve competitiveness and market position.
• Investment decision-making: Since profitability ratios provide a quick snapshot of a company's ability to generate profits relative to its size or resources, investors can use them to assess the potential return on their investments.
• Operational efficiency: Ratios like operating profit margin can highlight improvements in areas like pricing, cost management, and production (software products, services, or goods), among others. This insight allows management to strategize better to boost overall profitability.
• Financial planning: Profitability ratios help in setting realistic financial targets and developing strategies to achieve them. These ratios also guide decisions on reinvestment, expansion, or cost-cutting measures.
• Stakeholder communication: With profitability ratios, you can convey financial performance to stakeholders in a clear and concise way. They are often used in annual reports, investor presentations, and financial disclosures.
• Valuation: Profitability ratios are often used in company valuations, particularly in comparative analyses as they help determine the fair value of a company, which is crucial for mergers, acquisitions, or public offerings.
• Credit assessment: Lenders use profitability ratios to assess a company's loan repayment ability. Strong profitability ratios, as one can guess, lead to better credit terms and increased access to capital.

Limitations of profitability ratios  

While profitability ratios are indeed valuable tools for financial analysis, they do come with their set of limitations: 

• Potential for manipulation: It is possible for companies to artificially inflate their perceived performance with profitability ratios, misleading investors and stakeholders. 
• Risk of calculation errors: There’s always the underlying risk of calculation errors, leading to miscalculated ratios. These inaccuracies can translate into misguided decisions based on faulty data.
• Risk of skewed interpretation: High ratios may sometimes occur as a result of one-time events that could skew the numbers. Therefore, it is crucial to examine the context behind the numbers to confirm the validity of the analysis.
• Limited scope: Profitability ratios are “one-dimensional” as they focus solely on financial aspects and may not capture other important factors such as market position, brand value, growth potential, and customer satisfaction, among other parameters, which are also crucial for long-term success. 
• Time frame limitations: Profitability ratios are mostly calculated based on historical data and may not accurately predict future performance. Also, as one can imagine, a company’s future performance can be heavily impacted by external factors such as recession, inflation, changes in regulatory requirements, or changes in interest rates etc. These limitations need to be accounted for before making decisions.
• Industry variations: Profitability ratios can vary significantly across different industries, making cross-industry comparisons potentially misleading. 
• Accounting method differences: Companies may use different accounting methods, which can affect profitability ratios and thus make comparisons less meaningful.
• Size discrepancies: When comparing companies of different sizes, profitability ratios may not provide a complete picture, as larger companies might have economies of scale that smaller ones can't match (yet). 

Given these limitations, profitability ratios must be used as part of a broader financial analysis, considering multiple data points and qualitative factors to gain a comprehensive understanding of a company's financial health and future prospects.

Leveraging profitability ratios for smart decision making 

Profitability ratios are indispensable tools in financial management as they offer much-needed insights into a company's financial health, operational efficiency, and competitive standing. 

By leveraging these ratios, businesses and investors can measure success over time, track improvements, benchmark against competition, or identify areas of concern.

However, manual calculation and analysis of these ratios can be time-consuming and prone to human errors. This is where a financial planning and analysis (FP&A) tool like Drivetrain can help, 

Drivetrain’s platform can integrate data from various sources into a single, unified system, thereby eliminating silos and reducing errors. Users can also seamlessly slice and dice financial data in real time and get more nuanced insights into profitability.

With our customizable dashboards, you can focus on the metrics that matter most to your business. Finally, with Drivetrain’s scenario planning capabilities, you can model various financial futures and gauge the impact on profitability. 

Learn more about how Drivetrain can power your profitability analyses.