Profitability ratios act as a vehicle to allow the measurement of performance. One interesting advantage of linking profitability ratios is the ability to identify trends before they fully materialize into the market. 

They also act as comparison metrics for operations and financials. These metrics help to assess the performance not only internally but also with the competitors in the market. With the ratios aiding the management, they can aim for better performance and efficiency.

The following are 8 such important profitability ratios:

Gross Profit Margin

Gross Profit Margin is a ratio used to measure company’s profitability by comparing its gross profit to the revenue. This helps to assess and understand the management’s efficiency in managing production costs. It also gives an indicator of the ability of the company to generate profits. 

Gross Profit Margin aids in an effective pricing strategy that generates sufficient profits. Comparing gross profit to revenue allows for identifying cost issues. For example, if the margin has reduced from the previous quarter, leaders can assess why it happened. If the margin has reduced, it could be because one of the vendors has increased the price, in such cases the leaders can scout for other vendors who offer competitive prices. 

Operating Profit Margin 

Operating profit is the profit that is generated after deducting the Cost of goods sold and operating expenses. Operating Profit Margin is calculated by dividing operating profit by revenue. 

FP&A teams can use the Operating Profit Margin to benchmark performance to competitors, industry averages and identify areas for improvement. Operating Profit Margin also helps FP&A teams determine the most profitable product line to ensure the availability of resources according to the requirements. 

Net Profit Margin

Net Profit shows the left-over dollar value after all expenses are paid. Net profit Margin is calculated by dividing net profit by total revenue. It helps FP&A teams monitor the overall profitability of the organisation. By comparing Net Profit Margin, the team can also evaluate the efficiency of the organisation.

If the net profit is constantly declining, the FP&A team may need to check for any cost pressures or any inefficiencies in the overall process. Like other ratios, Net profit margin too helps in finding areas of improvement. 

Return on Assets (ROA) 

ROA is a ratio that indicates a company's profitability in terms of its assets. A high ratio indicates that the assets are being used efficiently and a lower ratio indicates inefficient use of assets. 

By comparing the year-over-year return on assets, leaders can also identify the utilisation trends of resources, as efficient utilisation of resources will ensure the organisation's overall financial health is good. FP&A teams should use this indicator to find improvement areas, make resource allocation decisions, and drive in more investments. 

Return on Equity (ROE) 

ROE is a ratio that gives the profit in terms of the investments made by shareholders. It is the one metric to measure company’s ability to generate profits and is critical to make investments. 

FP&A teams can identify the overall trends in profitability, whether it has been upward or downward. As ROE gives the ability to measure capability, it helps to set goals or pivot accordingly to the movement of ROE. ROE is also a key investment metric, showing how much investors will receive as potential returns.

Debt to Equity Ratio

The debt to Equity ratio is an indicator of the financial stability of the company. It measures relative owner earnings in terms of the total debt the company owes. A high ratio means the company is at a greater financial risk.  Finance teams work towards reducing the ratio in most cases.. 

The D/E ratio might also have a different meaning according to industry or context. For example, some industries have high Debt to Equity ratios, like real estate, as they are very capital-intensive businesses. 

Price to Earnings (P/E) Ratio

The P/E ratio is the most common method used to determine or evaluate the organisation's valuation. It measures the share price to the earnings per share. FP&A teams rely on the P/E ratio for several things..

A high ratio indicates the market sees potential in the organization's earnings. As it gives a company valuation, it is also used to compare with the peers in the industry. The P/E ratio is also used to project future earnings, which helps the team plan finances based on the future earnings of the project. 

Earnings Before Interest and Taxes (EBIT) Margin. 

EBIT Margin measures the proportion of revenue after all operation expenses, without deducting interest and tax. It primarily measures operational efficiency and determines the effectiveness of cost controls.  

For FP&A teams, it gives insight into the company’s potential earnings and its cash flow. FP&A teams use EBIT Margin to ascertain the impact of changes in revenue, costs, or other ops metrics. EBIT Margin also helps forecast or evaluate the potential profitability of projects under consideration.

Profitability ratios act as comparison metrics for understanding and assessing the financial health and performance of the organisation. Apart from this, they help identify trends before they happen, giving insights on what resources need to be allocated to which team and, most importantly, identifying areas of improvement.