Profitability Ratio

What is Profitability Ratio?


Profitability Ratios are metrics used to assess the profit potential of a business relative to its operating costs, sales revenue, balance sheet, assets, and shareholders' equity. It belongs to a class of financial metrics that helps in a company's performance measurement, using data reference for a specific time frame.

Profitability Ratio Analysis serves both the stockholders and creditors since the profits are distributed in the form of dividends, not to mention profits being used to cover debts.

Profitability Ratios are generally divided into two categories:

  1. Margins - which demonstrates the company's ability to churn profits out of sales.
  2. Returns - which indicates the company's ability to generate returns for its shareholders.

Some Profitability Ratio examples are the Profit Margin, Return on Assets (ROA), and Return on Equity (ROE).

This article will explain Profitability Ratios and how to calculate them. We will also discuss different types of Profitability Ratios and why this data is important for a business in the first place.

Key Takeaways:


- Profitability Ratios are financial metrics that calculate an entity's ability to generate income based on its operating costs, shareholders' equity, revenue, balance sheet, assets, etc.

- Profitability Ratios indicate the efficiency of an organization to earn profit and value for stockholders.

- Profitability Ratios enable a company to gather significant information by comparing the results with its past performance, other similar companies, or the industry in general.

- Higher Profitability Ratios are always more beneficial for a company.

Why Do Profitability Ratios Matter for a Business?


The main concern of any business is to make a profit. Profitability Ratios are the simplest way to convey a company's profit situation to its owners or shareholders.

What is a good Profitability Ratio? Here are some points explaining how good Profitability Ratios impact a business.

Compare Your Company's Performance with Competitors

If you are a small business or a startup, your income is probably not at par with a larger organization of the same industry. This is where Profitability Ratios help your business. It indicates how your business is performing compared to others. Simultaneously, it also shows that lesser income than another company does not necessarily make your business less profitable.

Draw More Investors:

Before investing in a company, any investor wants to know whether the firm can generate a decent profit margin. The organization's Profitability Ratios can easily analyze and demonstrate the business performance to the investors.

Improve Your Business:

The Financial Statements of a company is essential to understand the financial health of the firm. However, these numbers alone might not present the full picture. If you include Profitability Ratios in such situations, you will be aware of your company's performance in all areas.

Profitability Ratios: Types, Formulas, and Analysis:


Various types of Profitability Ratios exist that analyze and describe the financial situation and its overall performance on different parameters.

Profitability Ratios aim to evaluate the company's capacity to generate profit. These are critical markers for both the owners and the investors, as the company's profitability helps decide future business strategy and future investments, respectively.

Profitability Ratios are measured over two groups of ratios: margins and returns. Read on to find the list of Profitability Ratios.

A. Margin Ratios:

Margin Ratios indicate the capability of a company to generate profits from sales. The degrees of measurements are:

  1. Gross Profit
  2. Net Profit
  3. Operating Profit Ratio

B. Return Ratios:

Return Ratios show the ability of a company to generate returns to its shareholders. The types of returns include:

  1. Return on Equity
  2. Return on Assets
  3. Return on Capital Employed

Here, we will briefly analyze and explain how to calculate Profitability Ratios. We will also provide the Profitability Ratio Formulas that are typically used to calculate the ratios.

1. Gross Profit:

These types of ratios demonstrate the profit accrued with respect to the operating costs of the company. A high gross profit ratio reflects positively on the company's ability to cover operating expenses, fixed costs, dividends, and depreciation, while also generating net earnings for the business. In contrast, a low gross profit ratio reflects poorly on the company, indicating a high-cost price of sold goods, which can be due to low selling process, low sales, adverse purchasing and marketing policies, or severe market competition.

Formula: Gross Profit Ratio = Gross Profit ÷ Net Sales × 100

Where,

Gross Profit = Net Sales – Cost of Goods Sold (COGS)

Net Sales = Gross Sales – Sales Return – Discount Allowed

2. Net Profit:

This type of profit demonstrates the company's overall profitability, considering direct and indirect costs. It provides a wholesome outlook of a company's net profitability considering all expenses, including interest and taxes. Although it provides an overall picture, one of its drawbacks is that it also includes one-time expenses and gains, which may adversely affect its performance with respect to its competitors. 

Formula: Net Profit Ratio = Net Profit ÷ Net Sales × 100

Where,

Net Profit = Gross Profit + Indirect Income – Indirect Expenses

Net Sales = Gross Sales – Sales Return – Discount Allowed

3. Operating Profit Ratio:

These types of ratios indicate their ability to maintain operating expenses as profit percentages before interest expense and tax deductions. A higher ratio means a company is better equipped to pay for fixed costs and interest on obligations, handle economic slowdowns, and can offer lower prices than their competitors with a lower profit margin.

Formula: Operating Profit Ratio = Operating Profit ÷ Net Sales x 100

Where,

Operating Profit = Gross Profit – Operating Expenses – Depreciation and Amortization

Net Sales = Gross Sales – Sales Return – Discount Allowed

4. Return on Equity:

This type of return indicates the profitability of the equity fund invested in the company, i.e., the return on the sum of money investors have put into the business. A high ROE is generally one of the major reasons for the sale of the company's stocks. 

Formula: Return on Equity = Net Profit after Taxes ÷ Shareholders' Equity x 100

Where, Shareholders' Equity = Equity share capital, and Reserve, and Surplus

5. Return on Asset:

This type of return shows the profit made by a company relative to the total assets employed. This ratio also demonstrates the asset intensity of a business. A lower ROA suggests a more asset-intensive company, whereas a high ROA shows more profitability against the company's number of assets to operate.

Formula: Return on Asset = Net Profit after Taxes ÷ Total Assets x 100

Where,

Net Profit After Tax = Net Profit Before Tax – Taxes

6. Return on Capital Employed:

Return on Capital (ROC) is a measure of the overall return generated against the company's business's overall investment. This is analogous to the ROE ratio but more comprehensive since it includes the returns on bondholders' capital investments.

Formula: Return on Capital Employed = Earnings Before Interest and Tax ÷ Capital Employed x 100

Where,

Earnings Before Interest and Tax = Net Profit Before Interest and Tax

Capital Employed = Total Assets – Current Liabilities

Conclusion:


So, what is the Profitability Ratio?

To put it simply, Profitability Ratios are a financial metric that shows if a company is earning a healthy profit margin.

It is a useful practice to keep track of Profitability Ratios even if a company has not reached the stage to seek investment. However, if these calculations are not done consistently, the results can be misleading. Therefore, tracking profitability over a time frame is the best way to go. You can start the process with a small set of reports and run them routinely. The next time, you can include more reports as your business expands and gain more insight to improve your business performance.

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