Financial Analysis

Profitability Ratios

Profitability ratios are the financial ratios which talk about the profitability of a business with respect to its sales or investments. Since the ratios measure the efficiency of operations of a business with the help of profits, they are called profitability ratios. They are quite useful tools to understand the efficiencies / inefficiencies of a business and thereby assist management and owners to take corrective actions. 

Profitability ratios are the tools for financial analysis which communicate about the final goal of a business. For all the profit oriented businesses, the final goal is none other than the profits. Profits are the life blood of any business without which a business cannot remain a going concern. Since, the profitability ratios deal with the profits, they are as important as the profits.

The purpose behind calculating the profitability ratios is to measure the operating efficiency of a business and returns which the business generates. The different stakeholders of a business are interested in the profitability ratios for different purposes. The stakeholders of a business include owners, management, creditors, lenders etc. 

Types of profitability ratios:

 Profitability Ratios Chart

Formula for Profitability Ratios

Based on Sales:

1. Gross Profit Margin / Ratios:

Gross Profit Margin / Ratios

=

Gross Profit

Net Sales

2. Net Profit Margin / Ratios:

Net Profit Margin / Ratios

=

Net Profit

Net Sales

3. Expense Ratio:

Expense Ratio (Ex. Sales and Distribution)

=

Expenses (Ex. Sales and Distribution)

Net Sales

 

Based on Investment:

1. Return on Assets (ROA):

Return on Assets

=

Net Profits

Total Assets

2. Return on Capital Employed (ROCE):

Return on Capital Employed (ROCE)

=

Net Profits

Capital Employed

3. Return on Equity or Shareholders:

Return on Equity

=

Net Profits

Shareholder’s Funds

 

 

Uses of Profitability Ratios

 

The profitability ratios are useful to get insight of a business. It helps an analyst to get indication on the sufficiency or adequacy of profits. It finds out the rate of return and makes the business comparable to the industry as well as its own past. These ratios are used by banks and financial institutions while lending to the business as the ratios ensures them about the regular payments of interest and installments. Not only the bankers but owners also look at these ratios to know about the fruits, their investment is going to reap. Management follows and analyses these ratios to spot out the lacuna in their operations and thereby bring about the necessary improvements.