Profitability ratios measure how effectively a company converts revenue into profit at each level of the income statement. Leverage ratios measure the degree to which a company uses debt to finance its assets, and whether it can service that debt. Together, they form the second and third legs of comprehensive ratio analysis — moving from 'how efficiently does the business operate?' to 'how profitable is it?' and 'is it taking on sustainable debt levels?'
Margin ratios trace how each dollar of revenue flows through the income statement. Each margin level answers a different question about the business's economics:
Margin Waterfall — From Revenue to Net Income
Illustrative technology company · $2,800M revenue · Each step shows % of revenue
Revenue
+100.0%
$2800M
Cost of Revenue
-20.0%
$560M
Gross Profit
+80.0%
$2240M
Operating Expenses (R&D + SG&A + SBC)
-50.0%
$1400M
EBIT (Operating Income)
+30.0%
$840M
D&A Add-back
+6.4%
$180M
EBITDA
+36.4%
$1020M
Interest + Other
-2.3%
$65M
Income Taxes
-6.4%
$180M
Net Income
+21.2%
$595M
Gross Margin
80.0%
Pricing power
EBIT Margin
30.0%
Operating efficiency
EBITDA Margin
36.4%
Cash proxy (pre-capex)
Net Margin
21.2%
Equity holder return
EBITDA vs. Net Margin Gap
EBITDA margin (36.4%) exceeds net margin (21.2%) by 15.2 percentage points — reflecting interest expense, taxes, and importantly: D&A adds back only the non-cash charge, not capex (the real cash cost of maintaining assets).
Gross-to-EBIT Drop
Gross margin 80% → EBIT 30% — a 50-point drop entirely from operating expenses (R&D, sales, marketing, SBC). This is the "cost to run the business" beyond just producing the product. Compare across years to track operating leverage.
Figure 5.1 — Each step shows how much revenue dollar remains after each cost layer. The gap between EBITDA and net margin reflects interest, taxes, and the non-cash EBITDA add-back for D&A.
| Margin | Formula | What It Captures | What Drives It |
|---|---|---|---|
| Gross margin | (Revenue − COGS) ÷ Revenue | Profitability after direct costs of production; the business's fundamental pricing power vs. input costs | Pricing power, input cost structure, product mix, manufacturing efficiency |
| Operating margin (EBIT margin) | EBIT ÷ Revenue | Profitability after all operating costs including SG&A and D&A; the core business's earning power | Operational efficiency, SG&A leverage (fixed cost spread over more revenue), D&A load |
| EBITDA margin | EBITDA ÷ Revenue | Operating profit before non-cash D&A; closer to operating cash generation; used for cross-industry comparisons | Same as EBIT margin but adds back D&A — useful for comparing capital-intensive vs. capital-light businesses |
| Net margin | Net income ÷ Revenue | Bottom-line profitability after interest and taxes; affected by capital structure (interest) and tax efficiency | Everything above + interest burden + tax rate + non-operating items |
Gross margin reveals the fundamental economics of the product or service before overhead. High and stable gross margins (software: 60–80%, pharmaceuticals: 70–90%) indicate pricing power and low variable cost structures — these businesses can spread fixed costs across many units and see dramatic operating leverage. Low gross margins (grocery: 25–30%, discount retail: 30–35%) indicate commodity-like competitive dynamics where margins are competed away. Once you know the gross margin profile, you know what kind of business you're analyzing. Gross margin is harder to manipulate than net margin — it requires fewer accounting judgments.
Return ratios measure how much profit the company generates relative to the capital invested. These are the crucial bridge between profitability and capital efficiency:
| Ratio | Formula | What It Answers | Key Nuance |
|---|---|---|---|
| Return on Assets (ROA) | Net income ÷ Average total assets | How many cents of profit per dollar of assets deployed, regardless of how those assets were financed | Affected by leverage: high leverage = smaller asset base relative to equity = inflated ROE vs. ROA; use for asset efficiency assessment |
| Return on Equity (ROE) | Net income ÷ Average shareholders' equity | How many cents of profit per dollar of equity shareholders have invested; the primary equity investor return metric | Can be artificially inflated by leverage (borrowing to invest raises ROE) or buybacks (reducing equity base); decompose via DuPont (Lesson 14) |
| Return on Invested Capital (ROIC) | NOPAT ÷ Invested capital (Equity + Debt − Cash) | Most comprehensive return metric; measures return on all capital deployed in the business, debt + equity, before financing effects | Best for comparing companies with different capital structures; ROIC vs. WACC is the fundamental value creation test |
Value is created when ROIC > WACC. Value is destroyed when ROIC < WACC. The spread (ROIC − WACC) × Invested capital = Economic profit (EVA). A company that earns 15% ROIC with a 9% WACC creates $6 of economic profit per $100 invested annually. A company that earns 7% ROIC with a 10% WACC destroys $3 per $100 annually — even if it reports positive net income. Many acquisitive companies with modest organic ROIC look profitable on GAAP but destroy value over time because they cannot deploy the capital at returns exceeding their cost of capital.
Leverage ratios measure how much debt a company carries relative to its equity, assets, or earnings, and whether it can service the debt payments from operating cash flows:
| Ratio | Formula | What It Measures | Benchmark |
|---|---|---|---|
| Debt-to-equity (D/E) | Total debt ÷ Shareholders' equity | Proportion of financing from debt vs. equity; higher D/E = more leverage and financial risk | <1.0x conservative; 1–2x moderate; >3x high leverage (except utilities, REITs where it is structural) |
| Debt-to-EBITDA | Net debt ÷ EBITDA | Years of EBITDA needed to repay debt; the most common credit leverage metric used by lenders and rating agencies | <2x: investment grade low leverage; 2–4x: moderate; 4–6x: leveraged (high yield territory); >6x: stressed |
| Interest coverage ratio (TIE) | EBIT ÷ Interest expense | How many times the company can cover its interest expense from operating earnings; the key solvency test | >5x: comfortable; 2–5x: watch; <2x: distress risk; <1x: interest not covered by operations |
| Fixed charge coverage | (EBIT + Lease payments) ÷ (Interest + Lease payments) | Broader than TIE — includes all fixed charges including lease obligations (relevant since ASC 842 brought leases on-balance-sheet) | >2x generally adequate |
Key Takeaways
Revenue = $2,000M; COGS = $1,200M; SG&A = $400M; D&A = $100M; Interest = $50M; Tax rate = 25%. Calculate gross margin, EBIT margin, EBITDA margin, and net margin.