What are Profitability Ratios?
Profitability ratios are the financial ratios that talk about the profitability of a business concerning its sales or investments. Since these ratios measure the efficiency of operations of a business with the help of profits, they are called profitability ratios. They are valuable tools to understand the efficiencies and inefficiencies of a business and thereby assist management and owners in taking corrective actions.
Importance of Profitability Ratios
A business (unless a non-government organization) starts with a motto of making a profit, and thus one of the most commonly used financial ratios is profitability ratios. Look at the following points explaining the importance of profitability ratios.
- What are Profitability Ratios?
- Importance of Profitability Ratios
- Types of Profitability Ratios
- Example of Profitability Ratios with Calculation
- Uses of Profitability Ratios
Act as Evaluation Criterion
Management and investors often calculate these ratios, and they are always present in the annual reports of the company. Since every business wants to generate profit and the investors want returns on their investments, it is mandatory to showcase how the company is working and generating profit. Thus, profitability ratios analysis is a critical evaluation criterion for companies.
Communicate Final Goal of Every Business
Profitability ratios are the tools for financial analysis that communicate the business’s final goal. For all profit-oriented enterprises, the final destination is none other than profits. Profits are the lifeblood of any business, without which a company cannot remain a going concern. Since the profitability ratios deal with the profits, they are as important as the profits.
Measures Operating Efficiency
The purpose of calculating the profitability ratios is to measure the operating efficiency of a business and the returns that the company generates. The different business stakeholders are interested in the profitability ratios for various purposes. The business stakeholders include owners, management, creditors, lenders, etc.
Types of Profitability Ratios
Profitability ratios are a bunch of financial metrics that measure the profit generated by the company and its performance over time. The company’s profit, assessed by these ratios, can be defined or explained as the amount of revenue left after deducting all the expenses and losses incurred in a similar period to generate that revenue.
Ultimately, these ratios are nothing but a simple comparison of various levels of profits with either SALES or INVESTMENT. So, these ratios can be further classified as Margin Ratios (Sales based Ratios) and Return Ratios (Investment based Ratios). There are different ratios under this profitability ratio category which are as below.
There are broadly four margin ratios: gross profit margin, net profit margin, and operating profit margin and expense ratio.
Gross Profit Margin
This is the ratio used to understand how much cost is incurred to manufacture a product. It also helps in understanding the company’s efficiency and how it is using its resources to produce the product and then make a profit by passing the cost incurred to the consumers of the product.
|Gross Profit Margin = (Gross profit / Net Sales )*100|
Read GROSS PROFIT PERCENTAGE for enhanced coverage of this ratio.
Net Profit Margin
It is the most common profitability ratio used to measure the profit after deducting all the expenses, losses, and provisions for bad debt. It measures how much you make out of every penny you spend on the business. For example, if you have a net profit margin of 10%, then on every 1 rupee that you have invested in the business, you earn 10 paise.
|Net Profit Margin = (Net Profit / Net Sales)*100|
For an in-depth understanding of this ratio, visit NET PROFIT MARGIN.
Operating Profit Margin
This is the metric used to evaluate the company’s operating efficiency. EBIT, i.e., earnings before interest and taxes, are calculated to understand how much profit the company has generated from its core operation. The operating profit margin evaluates this EBIT as a percentage of sales to understand the efficiency of the company’s operations.
|Operating Profit Margin = (Operating Profit / Net Sales)*100|
For complete knowledge, read OPERATING MARGIN RATIO.
Expense ratios are a comparison of any particular type of expense to sales. These expense ratios could be as many in numbers as the no. of important expense categories. Say, for example, sales and distribution, administration, etc.
|Expense Ratio = Expenses (Ex. Sales and Distribution) / Net Sales|
Learn more at OPERATING RATIO.
There are mainly five return ratios, return on assets, return on equity and return on capital employed, return on investment, and return on net worth.
Return on Assets (ROA)
It is the profitability ratio that is used to evaluate the company’s level of efficiency in employing its assets to generate profit. The assets of the company, if not used optimally, will not be able to make the desired amount of profit, and the return will also be lower.
|Return on Asset = ( Net Income / Assets)*100|
Detailed post here at RETURN ON ASSETS.
Return on Equity (ROE)
Every equity investor looks for this ratio before investing in any company as it gives insight into the company’s profit-generating ability to the investors. The potential and existing investors keep a check on this ratio as it measures the return on the investment made in shares of the company. In general, the higher the ratio, the more favorable for investors to invest in the company.
|Return on Equity = (Net Income / Shareholder’s Equity Investment)*100|
Read exclusively about RETURN ON EQUITY here.
Return on Capital Employed (ROCE)
This is a third ratio that covers the equity and debt part. Total capital employed in place of equity capital is used as the denominator to calculate this ratio.
|Return on Capital Employed = Net Income / Capital Employed|
Read a detailed write-up about RETURN ON CAPITAL EMPLOYED here.
Return on Investment (ROI)
ROI is a very useful tool for evaluating investments. It compares the profits earned from investments with the cost incurred on these investments.
|Return on Investment = Net Income from Investment / Cost of Investment|
Read RETURN ON INVESTMENT for more details.
Return on Net Worth (RONW)
This return ratio is calculated from the investors’ viewpoint. It determines the profit that a company generates using its investments.
|Return on Net Worth = Net Income / Shareholders’ Equity|
For more detail, refer to RETURN ON NET WORTH.
Example of Profitability Ratios with Calculation
Suppose Ayur & Co. makes a net profit of Rs 1,00,000, and the gross profit is Rs 1,50,000. Net sales in the year amount to Rs 5,00,000, interest Rs 10,000 and taxes Rs 20,000. The company has 10,00,000 invested in the assets, and equity investments or paid-up capital is Rs 12,00,000.
Gross Profit Margin = (Gross profit / Net Sales )*100
= (Rs 1,50,000/ Rs 5,00,000)*100 = 30%
Net Profit Margin = (Net Profit / Net Sales)*100
= (Rs 1,00,000/ Rs 5,00,000)*100 =20%
Operating Profit Margin = (Operating Profit / Net Sales)*100
= (EBIT/Net Sales)*100 = ((Rs 1,00,000+Rs 10,000+ Rs 20,000) / Rs 5,00,000)*100 = 26%
Return on Asset = ( Net Income / Assets)*100
= (Rs 1,00,000/ Rs. 10,00,000)*100 =10%
Return on Equity = (Net Income / Shareholder’s Equity Investment)*100
= (Rs 1,00,000 / Rs 12,00,000)*100 =8.33%.
Uses of Profitability Ratios
The profitability ratios are used to get an insight into a business. It helps an analyst get an indication of the sufficiency or adequacy of profits. It finds out the rate of return and makes the business comparable to the industry and its past. These ratios are used by banks and financial institutions while lending to the business as the ratios ensure the regular payments of interest and installments. The bankers and owners look at these ratios to know about the fruits their investment is going to reap. Management follows and analyses these ratios to spot the lacuna in their operations and bring about the necessary improvements.
Refer to ADVANTAGES & DISADVANTAGES OF PROFITABILITY RATIOS for more details.
Uses of profitability ratios are different for the management and the investors, but the motto behind calculating them is to evaluate the profit and performance of the company. Different profitability ratios measure profitability based on various aspects of a business and help the management work more efficiently to generate more profits.
Refer to RATIO ANALYSIS for getting insights about other types of ratios.
Quiz on Profitability Ratio
This quiz will help you in taking a quick test of what you have read