Using profitability ratios to attract investors and find success
Small businesses are at their best when they're thinking ahead. Few things can bring a business down like poor profitability, so few things can help a business succeed like knowing how to find your profitability ratios.
Your company's profitability largely determines whether or not your company will thrive. To ensure your company is on the right path, let's take a look at what profitability ratios are, which financial metrics are involved in finding them, and when to use each type of profitability ratio.
What's a profitability ratio?
Profitability ratios are used to predict the financial ability of a company. More specifically, profitability ratios help companies determine if they're going to be capable of generating a profit after factoring in all of their costs. This information can tell you if your company is on the right course, and is helpful in attracting new investors.
If an investor is interested in your company, they'll want to know they're making a good investment. Being able to leverage ratios to show your company's profitability will give investors far more confidence than simply showing them a sales revenue statement.
A profitability ratio factors in operating costs, non-operating expenses, and additional financial aspects of your operations, showing your business is truly profitable. (A business can have a high sales revenue and terrible overhead, resulting in poor financial performance.)
There are a number of profitability ratios, and each one can provide insight into your company's financial health. Before you can attract investors or get a better look at your company's bottom line, you need to understand the different types of profitability ratio. Each offers a different view of your finances that can appeal to different investors.
Types of profitability ratios
Each profitability ratio takes into account a different type of cost, and appeals to different kinds of investors. Where one investor might be interested in how equity factors into your profitability, another might be more interested in earnings before interest and taxes.
Knowing your profitability is a responsibility of all business owners, so without further ado, let's take a look at the major profitability ratios and how they work.
Gross profit margin ratio
The gross profit margin ratio looks at your company's gross profits after considering the cost of goods sold (COGS). You can find your gross profit margin using the following equation:
Gross profit margin = gross profit ÷ sales
Your gross profit margin is an excellent indicator of how your business is performing in your niche, as it factors in the COGS. The higher your gross profit margin, the more successful your business is at countering the costs of manufacturing goods. If your gross profit margin is going down, it could indicate that you’re spending too much to make your goods, or you're simply in a competitive, costly industry.
While a deeper financial analysis is necessary to ultimately determine how your business is doing, a high gross profit margin is typically a strong signal to investors that your business is a wise investment.
Net profit margin ratio
Where your gross profit margin gives you profit after COGS, net profit tells you how much profit you're making after factoring in operating expenses, non-operating expenses, and taxes. You can find your net profit by using the following equation:
Net profit margin = net income ÷ revenue
Your net profit margin uses your net income, meaning your income after any and all expenses have been accounted for. Your net profit margin gives you a more accurate view of your overall business performance than the gross profit margin.
While net profit margin won't point to specific issues like gross profit (such as your COGS being too high), it will give investors an accurate snapshot of your company's overall performance.
Operating profit ratio
Your operating profit margin is your gross profit minus operating expenses. Your operating costs can include a number of expenses, including rent, wages, and equipment costs. To find your operating profit ratio, use this formula:
Operating profit margin = operating income ÷ sales revenue
Your operating profit ratio provides insight on your overall costs of operating. The lower your operating profit margin, the more likely it is you're overspending on operations. Again, bringing in a lot of revenue isn't necessarily enough if you're spending too much to keep the lights on and your equipment running.
Cash flow margin ratio
Every business needs some kind of cash flow, be it positive or negative. A positive cash flow means you have more money coming in than going out, while a negative cash flow signals more money going out than coming in. Your cash flow margin is a measurement of how well your company turns sales into real, usable cash.
To find your cash flow margin, use this formula:
Cash flow margin = cash from operating activities ÷ net sales
No single cash flow margin is "good," but a higher cash flow margin tells investors your company does a good job of not only selling, but also turning that money into usable cash. The higher the cash flow margin, the more likely it is that a company has a good handle on expenses and debts. A high cash flow margin indicates that they're managing to take a sale and carry most of the money into profit and usable cash.
Return on assets ratio
The return on assets (ROA) ratio, also known as the return on investment ratio, examines your company's financial performance in relation to assets. Assets can be any piece of equipment or item that factors into your company’s ability to generate revenue. The lower the ROA, the more money you have tied up in assets. You can find your ROA using the following formula:
ROA = net income ÷ total assets
ROA is mostly useful for investors or potential buyers if you're selling your company. Investors or buyers can look at your ROA in comparison to others in your industry and see how well your company turns investments into profits.
This information is especially useful if you're in an industry with high asset costs, like 3D printing. If your company has a higher ROA than other companies in 3D printing, it shows you're turning a solid profit despite those high asset costs. As a result, your company is likely a better investment than competitors.
Return on equity ratio
The return on equity ratio shows how well your company does when it comes to turning an investor's money into more money. This is determined with the following formula:
Return on equity ratio = net income ÷ investor equity
The higher the return on equity ratio, the better a company is at turning a shareholder's equity into further profit. If you want to attract investors, this is a hugely important ratio. It is essentially the number at which an investor can expect to get a return on their investment.
If a company has a low return on equity ratio, it means they're taking in a lot of equity but not turning it into profit. This isn't necessarily a bad thing, as the company could be new and still using funding to get off the ground. But it's not going to inspire a lot of confidence in investors.
EBITDA, or Earnings Before Interest, Taxes, Depreciation, and Amortization, is a quick way of comparing one company's profitability to another.
As the name implies, your EBITDA is a look at your company's profitability before factoring in interest, taxes, depreciation, and amortization. This makes EBITDA a little less accurate, but it does give investors a quick way to see how your company stacks up against others in terms of general earnings. You can find your EBITDA using the following formula:
EBITDA = net income + interest + taxes + depreciation + amortization
While EBITDA doesn’t provide the same granular picture as the other profitability ratios mentioned, it does provide an image of your company without the impact of capital expenses or financing. The fact that it leaves these elements intact makes it easier to quickly compare your company to another in your industry without factoring in the outside element of financing or capital expenses.
Know your profitability, predict your future
Luck and fate have their place in life, but in business a lot of your success comes down to your powers of prediction. When you know how to determine your profitability ratios, you essentially have a glimpse into the future. This allows you to pivot ahead of time, reach out to investors when the time is right, and ultimately find success in a more predictable manner.
A lot of life is guesswork, but when it comes to business decisions, profitability ratios can help you make educated choices.