These are a few of Dawn’s favorite things.
Hint: It all comes back to cash.
When we talk about a business from an owner’s perspective, one of the first things most owners want to understand is profitability. That’s hardly a new concept. Businesses conduct operations with the intention of earning a profit.
But profitability isn’t captured by a single number.
Profitability ratios help us measure not only how much a business earns, but also how efficiently it generates those earnings. Looking at several of these ratios together can provide a much more useful picture of a company’s operations, financial health, and ability to turn revenue into cash.
Here are a few of my favorites.
Gross margin ratio
Formula: (Revenue − Cost of Goods Sold) ÷ Revenue
Gross margin measures how much revenue remains after accounting for the costs directly associated with producing the goods or services sold.
Generally, the higher the gross margin, the more effectively a company is using its direct costs to generate sales. It tells us how much of each sales dollar remains to cover the other costs of doing business and, ultimately, contribute to profit.
This makes gross margin an important measure of both profitability and operating performance.
EBITDA margin
Formula: Earnings Before Interest, Taxes, Depreciation and Amortization ÷ Revenue
EBITDA margin is a popular profitability measure among business owners and investors because it focuses on earnings before the effects of financing decisions, taxes, depreciation, and amortization.
It provides a useful way to evaluate the profitability of the company’s core operations relative to its revenue.
A higher EBITDA margin generally indicates that a greater percentage of revenue is being converted into operating earnings before those additional expenses are considered. That can provide valuable insight into how efficiently the underlying business is operating.
Net profit margin
Formula: Net Income ÷ Revenue
Net profit margin measures the percentage of sales remaining after operating and non-operating expenses have been accounted for.
Its importance is fairly obvious: a positive net profit margin means the company is earning more than it spends, and a higher percentage generally indicates greater profitability.
But net profit margin also needs context.
Net income can be affected by non-recurring items, gains, losses, and other activity that may not reflect the company’s normal operating performance. In some years, those items can make the bottom line look significantly better or worse without necessarily telling us how efficiently the underlying business is operating.
The way I look at it, if there is a significant difference between a company’s net profit margin and its operating profit margin, it deserves attention. Something outside the company’s core operations may be affecting the bottom line, and that impact could become more significant sooner rather than later.
Operating profit margin
Formula: Operating Income ÷ Revenue
In my opinion, operating profit margin is an excellent measure of both profitability and a company’s efficiency in managing the costs of doing business.
It shows the percentage of sales remaining after the day-to-day costs of conducting business have been paid.
That makes it particularly useful when evaluating the underlying operation itself: how efficiently the company manages its operating costs and converts its business activity into operating income.
For business owners, this is an important distinction. Revenue tells you how much you are selling. Operating profit helps tell you how effectively you are running the business that produces those sales.
Cash flow margin
Formula: Operating Cash Flow ÷ Revenue
Now we get closer to what all of this ultimately comes back to: cash.
Cash flow margin connects a company’s operating cash flow to the sales dollars it produces. The higher the percentage, the more operating cash the business is generating relative to its revenue.
This distinction matters enormously.
A company can generate a tremendous amount of revenue and still lose money or struggle to generate cash. High sales do not automatically mean a financially healthy business. If operating cash flow is consistently negative, the company may be producing plenty of sales dollars while simultaneously bleeding cash.
Cash flow and cash control are imperative to the financial health and continued operation of a business.
Strong cash generation gives a company greater flexibility to meet its obligations, manage economic downturns, repay creditors, invest in operations, and potentially make distributions to owners or shareholders.
Ultimately, cash flow helps answer one of the most important questions about a business: Is the company generating enough cash from its operations to support itself and continue moving forward?
Return on equity
There are also equity ratios worth understanding, including return on equity.
Formula: Net Income ÷ Shareholders’ Equity
Return on equity measures the amount of profit generated relative to shareholders’ equity. In other words, it helps show how efficiently a company is using the capital invested by its owners to generate profit.
Business owners want a return on their capital. Investors want to understand what their capital is producing. Creditors, meanwhile, are looking at financial ratios to assess the company’s ability to meet its obligations.
Different parties may approach the financial statements with different interests, but they are often trying to answer variations of the same fundamental questions.
It all comes back to cash.
Understanding financial ratios is crucial to making informed business decisions and assessing risk. No single ratio tells the entire story.
Taken together, however, these measures provide insight into a company’s profitability, liquidity, solvency, operating efficiency, and overall financial health. They can help an owner see not simply what the business earned, but how effectively the company is operating and what financial resources those operations are producing.
At the end of the road, several people eventually come to the table: owners, investors, lenders, creditors, and other stakeholders.
They may calculate different ratios. They may examine the business from different perspectives. But eventually, they all want to understand some version of the same thing:
Can this business generate cash? Can it use that cash efficiently? And will there be enough cash available to meet its obligations, reward its investors, and continue operating?
Revenue matters. Profit matters. Efficiency matters.
But eventually, it all comes back to cash.
The numbers are only useful if you know what they’re telling you.
Understanding how profitability, efficiency, and cash flow work together can give you a clearer view of your business and the decisions ahead. If you’d like help making sense of what your numbers are telling you, our accounting team is here to help.
