   # Profitability Ratio

Guide to Understanding Profitability Ratios ## How to Calculate Profitability Ratio (Step-by-Step)

A profitability ratio divides a profit metric by the amount of revenue generated in the corresponding time period, which is insightful in terms of understanding a company’s historical spending trends.

For instance, most of a company’s spending could be related to cost of goods sold (COGS), operating expenses (OpEx), or non-operating items.

In practice, multiple profitability ratios should be used in conjunction with each other to measure a company’s true financial state and to develop a comprehensive understanding of its cost structure and business model.

The reliance on only one profit metric can lead to misguided interpretations, especially in the absence of a firm grasp of relevant industry-specific considerations.

## Profitability Ratio Formula

Formulaically, the structure of a profitability ratio consists of a profit metric divided by revenue.

Profitability Ratio = Profit Metric ÷ Revenue

The resulting figure must then be multiplied by 100 to convert the ratio into percentage form.

Once standardized, the ratio can subsequently be used for purposes of comparability, either to the company’s own historical performance or against its closest industry peers.

## Gross Margin Ratio Formula — Gross Profit to Revenue

The gross margin ratio compares a company’s gross profit to its revenue.

Since the gross profit metric deducts only one expense—the company’s cost of goods sold (COGS)—the gross margin ratio reflects the percentage of revenue left over after the direct operating costs have been taken into account.

Gross Margin Ratio = Gross Profit ÷ Revenue

The cost of goods sold (COGS) line item is found right below revenue (or sales) on the income statement, and represents the direct costs incurred by a company to generate revenue, e.g. direct materials and direct labor costs.

## EBIT Margin Ratio Formula — Operating Income to Revenue

The EBIT margin ratio, or “operating profit margin”, compares a company’s operating income to its revenue.

EBIT Margin Ratio = Operating Income ÷ Revenue

Operating income (EBIT) is a GAAP measure of profitability calculated by subtracting operating expenses like SG&A and R&D from gross profit.

Like COGS, operating expenses are also part of the core operations of a company, i.e. the costs that must be incurred for the company to continue operating.

However, the distinction is that operating expenses are not directly related to a company’s process of revenue generation.

Therefore, the EBIT margin ratio represents the percentage of profits remaining once both direct and indirect operating costs—COGS and OpEx—have been deducted from revenue.

## EBITDA Margin Ratio Formula — EBITDA to Revenue

The EBITDA margin ratio compares a company’s EBITDA to its revenue in the corresponding period.

EBITDA Margin Ratio = EBITDA ÷ Revenue

Unlike EBIT, EBITDA is a non-GAAP measure of profitability, so the metric is not typically found on the income statement.

Still, EBITDA is by far the most widely used measure of profitability and is calculated by adding depreciation and amortization (D&A) to EBIT.

Depreciation and amortization expense are non-cash items, meaning there is no real movement of cash associated with these line items.

Instead, these non-cash expenses are recognized on the income statement to abide by accrual accounting reporting standards.

• Depreciation → The allocation of the purchase cost of fixed assets (PP&E) over the expected useful life of the long-term asset, i.e. the capital expenditure (Capex) is periodically recognized, rather than all at once.
• Amortization → Similar to depreciation, amortization allocates the cost of intangible asset purchases over their useful life assumptions, although not all intangible assets can be amortized.

The EBITDA margin ratio thereby reflects the percentage of revenue remaining once all direct and indirect operating costs have been subtracted, with the additional step of removing the effects of non-cash items, namely D&A.

Because EBITDA is a non-GAAP metric, companies have the option to make additional discretionary adjustments, such as for stock-based compensation (SBC).

Therefore, it is essential to question and analyze each adjustment, as opposed to taking the EBITDA figures as stated by management (or by an equity analyst) at face value.

## Net Profit Margin Ratio Formula — Net Income to Revenue

The net profit margin ratio compares a company’s net income to its revenue.

Net Profit Margin Ratio = Net Income ÷ Revenue

The net income metric (i.e. the “bottom line”) is the revenue left over once all costs, operating and non-operating, are deducted.

In effect, the net profit margin ratio represents the accrual-based profitability of a company after subtracting all costs, including non-operating costs and taxes.

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## Profitability Ratios in Financial Analysis

To properly use profitability ratios in financial analysis and derive accurate insights, it is important to draw the line between operating and non-operating items.

While there are no issues with using a ratio such as the net profit margin—which is a levered metric (i.e. post-interest) and inclusive of the expenses or income from non-operating items—problems can emerge if the distinction is ignored.

Certain profit metrics such as gross profit, operating income (EBIT), and EBITDA are unlevered metrics (i.e. pre-interest), meaning that the effects of non-operating items are excluded.

By excluding non-operating items, the profit metric reflects the core operating performance of the company, without the impact of discretionary items such as interest expense and interest income, or one-time non-recurring items such as the gain (or loss) on the sale of an asset and inventory write-downs.

The interest expense incurred on debt obligations, such as loans or corporate bonds, are non-operating costs, since the capital structure is a discretionary financing decision. In other words, the decision on how a company’s operations are funded (equity vs. debt) is up to management discretion.

In practice, the EBIT and EBITDA margin are two of the most common profitability ratios, particularly for comparative purposes among peer companies.

Only the core operating profit metrics of companies—independent of financing decisions like the capital structure and jurisdiction-based expenses like income taxes—should be used in peer-to-peer comparisons.

Otherwise, there is substantial risk for misled interpretations due to the post-levered ratios being skewed by non-core, discretionary items, as well as by non-recurring expenses.

## Profitability Ratio Calculator — Excel Model Template

We’ll now move on to a modeling exercise, which you can access by filling out the form below. Submitting ...

## Step 1. Income Statement Assumptions

Suppose we’re tasked with calculating the profitability ratios of a company using the following income statement.

Income Statement 2021A
Revenue \$100 million
Less: COGS (50 million)
Gross Profit \$50 million
Less: SG&A (20 million)
Less: R&D (10 million)
EBITDA \$20 million
Less: D&A (4 million)
Operating Income (EBIT) \$16 million
Less: Interest (1 million)
Pre-Tax Income (EBT) \$15 million
Less: Taxes @ 20% Tax Rate (3 million)
Net Income \$12 million

As mentioned earlier, EBITDA cannot be directly reported on the income statement since it is a non-GAAP metric.

Instead, EBITDA must be manually calculated by finding the D&A expense on a company’s cash flow statement (CFS) and adding it back to operating income (EBIT).

## Step 2. Profitability Metrics Calculation Example

Using the figures from our hypothetical income statement, our next step is to calculate the profit metrics that’ll be part of our ratio calculations.

While the metrics are already provided on the income statement, we’ll still calculate them in Excel, rather than hard-coding the values.

• Gross Profit = \$100 million – \$50 million = \$50 million
• EBITDA = \$50 million – \$20 million – \$10 million = \$20 million
• Operating Income (EBIT) = \$20 million – \$4 million = \$16 million
• Pre Tax Income (EBT) = \$16 million – \$1 million = \$15 million
• Net Income = \$15 million – (\$13 million x 20%) = \$12 million

## Step 3. Profitability Ratio Calculation and Analysis

In the final step, we’ll divide each profit metric by revenue to arrive at the following profit ratios for our company in 2021.

The completed calculations of the profitability ratios are as follows.

• Gross Profit Margin Ratio = \$50 million ÷ \$100 million = 50.0%
• EBITDA Margin Ratio = \$20 million ÷ \$100 million = 20.0%
• EBIT Margin Ratio = \$15 million ÷ \$100 million = 16.0%
• Net Profit Margin Ratio = \$12 million ÷ \$100 million = 12.0%  Step-by-Step Online Course

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