Profitability Ratio: Definition, Formula, Examples

Profitability ratios are a type of financial tool that allows us to assess a company's ability to generate profits given its current level of expenses. The profitability ratio is used to assess a company's capacity to generate revenue about its expenses and other costs involved with revenue-generating during a given period. The final result of the company is represented by this ratio.

 

To examine how the business has done, these ratios take into consideration various parts of the income statement and balance sheet. The higher the value of these ratios in comparison to the competitors and the market, the better the company's performance. 

 

When analyzing the ratios, they are most beneficial when compared to similar companies or earlier eras. Below are some of the most widely used profitability ratios.

 

Also Read | Introduction to Ratio Analysis

 

What are Profitability Ratios and How Do They Work?

 

Profitability ratios are financial measurements that are used to assess and analyze a company's ability to make profits. These talents can also be evaluated for a certain period using the income statement, balance sheet, shareholder's equity, or sales processes. The profitability ratio also shows how effectively a company uses its assets to produce profits and deliver value to its owners.

 

A profitability ratio is also a useful tool for analyzing and comparing similar businesses or periods. As a result, any firm strives for a larger ratio, which indicates that the company is operating well in terms of revenue, earnings, or cash flow. It's preferable to have high profitability ratios. 

 

They indicate that the company has achieved high-profit levels with fewer assets or poorer asset utilization. Low-profit margins are unfavorable. This indicates that the company has squandered possibilities. Through better asset management, these opportunities could result in higher profitability. 

 

Profitability ratios are also used by most investors and creditors to evaluate a company's return on investment concerning its relative level of resources and assets. Furthermore, firm management examines these ratios to improve profitability by making required changes to business operations. High-profit margins are always a plus. 

 

They operate at a high level of effectiveness. Low profitability ratios are almost always a bad thing, but they aren't always. Low profitability may indicate that the company is still growing. It could be in a highly competitive industry.

 

Also Read | Capital Investment - Types, Advantages, and Limitations

 

Purpose of Profitability Ratio

 

Profitability ratios are financial analysis tools that communicate a company's ultimate purpose. Profits are the ultimate goal of all profit-oriented businesses. Profits are essential to any business's survival; without them, it would cease to exist. Profitability ratios are as significant as profits since they deal with profits.

 

The goal of calculating profitability ratios is to assess a company's operating efficiency as well as the profits it creates. Profitability ratios are important to many stakeholders in a business for various reasons. A company's stakeholders include its owners, management, creditors, and lenders, among others.

 

Types of Profitability Ratios

 

Profitability ratios are a set of financial measurements that track a company's profit and performance over time. The amount of revenue left after deducting all of the expenses and losses incurred in a similar period to generate that revenue can be simply defined or explained as the amount of profit left after deducting all of the expenses and losses incurred in a similar period to generate that revenue.

 

There are a variety of profitability ratios included in this category, which are listed below.

 

1. Gross Profit Margin

 

After deducting direct expenditures or the cost of products sold, the gross profit margin ratio is used to determine how much profit a company makes from its sales of goods and services. A higher gross profit also indicates that the corporation can cover operating expenses, fixed costs, depreciation, and other costs while still generating net income. 

 

A low gross profit margin, on the other hand, reflects adversely on the business, indicating a high selling price, little sales, expensive costs, fierce market rivalry, and so on. This ratio examines how successfully a corporation manages the expenses of inventory and product manufacturing, and then passes those costs on to its customers. The corporation benefits from a higher gross profit margin.

 

The formula is as follows:

 

Gross Profit Margin = ((Total Sales – Cost of Goods Sold or Production Costs) / Total Sales) x 100

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Different types of Profitability Ratios

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2. Operating Profit Margin

 

Operating margin accounts for costs of production that are not directly tied to the manufacturing of the product or services, such as overhead and administrative expenses. 

 

Companies with high operating profit margins are better able to cover fixed costs and interest on commitments, have a higher chance of surviving an economic downturn and can offer cheaper pricing than their competitors with lower profit margins. 

 

Because competent management may significantly improve a company's profitability by reducing its operational costs, the operating profit margin is usually used to gauge the strength of its management. 

 

Earnings before interest and taxes, or EBIT, is a metric used to determine how much profit a firm has made from its core operations. The operating profit margin measures EBIT as a proportion of sales to determine the efficiency of the company's operations.

 

The formula is comparable to the gross profit margin:

 

Operating Margin = ((Total Sales – Cost of Goods Sold – Operating Expenses) / Total Sales) x 100

 

Again, simplify this by reducing your net operating income number from your profit and loss statement by your total income amount, then multiplying by 100.

 

Also Read | Introduction to EBITDA

 

3. Net Profit Margin

 

The net profit margin is the most commonly employed margin ratio in a simple profitability ratio analysis. After all expenses are paid, the net profit margin reveals how much of each sales dollar remains as net income. It is used to calculate profit after all expenses, losses, and allowances for bad debt have been deducted. 

 

It calculates how much profit you get for every dollar you invest in the company. A larger net profit margin is better, much like a higher gross profit margin or operating profit margin, because the company makes more profit after paying all of its bills. It can be kept as internal capital to help the company thrive in the future. Some of it can also be paid to shareholders as dividends.

 

Non-operating income/expenses increases can wreak havoc on the net profit margin. When a firm announces divestiture proceeds, for example, it increases net income but not operating profit. 

 

As a result, the net profit margin appears to have improved dramatically from the previous year, even though the operating profit margin did not. The net income figure can be seen at the bottom of the income statement. We divide sales by margin to get the margin amount.

 

Net profit margin = Net profit / Revenue

 

4. Return on Assets (ROA)

 

The percentage of net earnings related to the company's total assets is known as return on assets (ROA). The ROA ratio expresses how much profit a corporation makes after taxes for every dollar of assets it owns. The return on assets (ROA) is a metric that assesses how effectively a company utilizes its assets to create profits. 

 

In other words, it is concerned with the amount of profit generated per rupee invested. It also calculates the company's asset intensity. As a result, a lower ROA suggests a corporation that is more asset-intensive. It also calculates a company's asset intensity. 

 

The lower a company's earnings per dollar of assets, the more asset-intensive it is thought to be. To produce revenue, very asset-intensive businesses must make large investments in machinery and equipment.

 

A larger ROA, on the other hand, implies that the company is profitable concerning the number of assets it manages. Furthermore, to produce revenue, organizations with a greater asset intensity must invest a large amount in machinery and equipment.
 

Net Profit After Taxes / Total Assets x 100 = Return on Assets

 

Where total assets refer to the total value of all assets on the balance sheet.

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Formulas of Different Profitability Ratios

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5. Return on Equity

 

The percentage of net income relative to stockholders' equity, or the rate of return on the money that equity investors have put into the business, is known as return on equity (ROE). Stock analysts and investors pay close attention to the return on investment (ROI) ratio. 

 

A high ROE ratio is frequently suggested as a rationale to invest in a company's shares. It also shows the returns on the money put in the company by the investors. Furthermore, investors and analysts frequently monitor ROE. It calculates the return on investment made by the company's investors. 

 

It's the ratio that potential investors consider when considering whether or not to invest in a business. Companies with a high return on equity are more likely to be able to generate cash internally, reducing their need for debt funding. 

 

Furthermore, a greater ROE ratio can be one of the factors to consider when purchasing a company's shares. Companies with a high return on equity are less reliant on debt funding since they can produce cash internally.

 

The formula for ROE is:

 

Net Profit after Taxes / Shareholder's Equity x 100= Return on Equity

 

Where Equity Share Capital Equals Shareholders' Equity

 

Also Read | Cost of Production - Meaning, Types, How to Calculate

 

Uses of Profitability Ratios

 

1. Profitability ratios are utilized to gain insight into a company. It aids an analyst in determining whether profits are adequate. It calculates the rate of return and compares the company to its competitors as well as its history. 

 

2. These ratios are utilized by banks and financial institutions when lending to businesses because they ensure that interest and installment payments will be made on time.

 

3. When the above ratios are compared from year to year, it becomes clear how well a company's financial performance relates to its potential to make profits. And, when combined with efficiency ratios, we can obtain a better idea of how effectively a corporation uses its internal assets to generate profits.

 

4. These ratios will provide us with more information if we compare them to peers or industry averages, in addition to analyzing the statistics historically. Higher numbers as compared to competitors or industry averages suggest that the company is more profitable.

 

Watch this | Ratio Analysis - Profitability

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Which Profitability Ratio is the Best?

 

The ability of a corporation to convert sales revenue into net profits is measured by profitability ratios. Other considerations must be taken into account as well. Choosing the best profitability ratio is an example.

 

The operating profit margin is frequently regarded as the best of the three. It indicates how successfully a company handles its expenses. After all, operating expenses have been removed from sales, this is the result.

 

For marketing purposes, the contribution profitability ratio is useful. It is used by the majority of businesses to assess their efficiency. Marketing initiatives and marketing budgets are included.

 

Also Read | Why Do we Need a Financial Budget?

 

Bottom Line: Incorporate the Profitability Ratio into Your Business

 

While it's tempting to celebrate your company's profit and loss statement because total and net income are both increasing, you don't want those dollar figures to become "vanity numbers." Small business owners that rely solely on changes in these metrics lose important information about their company's health.

 

Companies can use profitability ratios to better assess their short- and long-term prospects. It enables them to create a more effective company plan. It also aids in the difficult decisions that must be made at various stages of a business's lifespan. 

 

Other considerations must be taken into account as well. This aids in determining the appropriate profitability ratio. Operating margins are a way to assess a company's capacity to turn sales into a profit.

 

Consider the following scenario: Profitability ratios are a simple and straightforward way to objectively examine your company's P&L—information you can use to compare your company's performance to that of similar firms in your industry or to objectively analyze your company's financial condition over time.