ROI or Profit Margin: Which Is Better?

Simply knowing how much money you made last year isn't a good enough guide to how well your business is doing. Some inefficient companies generate lots of profits because of their size. Other businesses increase profits but spend too much money to do so. Good metrics, such as your return on investment and profit margin can give you a better sense of your company's performance.

To figure your company's return on investment, or ROI, divide the net profit by total assets. A $100 million company with a $10 million net profit has a 10 percent ROI. If you want to compare your performance to larger or smaller companies in your industry, ROI works as a metric, regardless of size. You can also use ROI to measure how different divisions of a company perform compared to one another or whether buying more assets is making your business more profitable.

Profit margin is another ratio: your profits divided by your company's sales receipts or costs. Suppose your corporation earns $15 million this quarter, and $3 million of that is profit. That gives you a profit margin of 2 percent compared to sales. The lower your company keeps its costs or the larger the profits on each transaction, the higher the margin. If costs rise but the sales stay constant, the profit margin shrinks.

You can use both ROI and profit margin to measure your profitability. Neither one is "better" in some absolute sense; it depends on what questions you want answered. If, for instance, you're pumping money into your business and you want to know the result of the added investment, ROI is the right metric. ROI won't tell you, however, how much profit your company brings in or whether you have enough cash flow to meet payroll.

If your primary concern is the bottom line, profit margin -- and variations, such as the gross profit margin -- may be more relevant. For example, if your profits are going up but your costs are going up faster, your profit margin is going to drop. That's a warning sign your business strategy has a problem. Even if the profits are good overall, you may discover individual product lines or services have unpleasantly low margins, a sign you might be better off without them.