Profitability Ratios – Types, Importance and Calculation
Investors use profitability ratios to assess a company’s capacity to earn profits in comparison to its total revenue and expenses. It is essential to check these metrics to understand a company’s strength to make profits via adept utilisation of assets.
This blog details the different types of profitability ratios, their importance, and calculation. Let’s dive in.
What are Profitability Ratios?
Profitability ratio is a metric that’s used to measure and evaluate a company’s ability to generate profits with respect to operating costs, revenue and balance sheet during a specific period of time.
To evaluate profitability ratios, the company considers its balance sheet, income statement, shareholders’ equity or sales processes up to a specific span. A high profitability ratio implies that a company generates enough profits for its shareholders.
With the help of the profitability ratio, an analyst can get an idea about the company’s business flow. As a ratio, it assists analysts in doing a comparative study of a firm’s profitability against other businesses. Analysts can use these ratios to conclude the company’s performance by comparing it with past performances.
What is the Importance of Profitability Ratio?
Here is why profitability ratios are essential metrics for both investors and companies.
- They indicate how efficiently a company can use its assets to generate maximum profits.
- Profitability ratios also work as a metric to compare profits with rival companies and their past data.
- Analysts use profitability ratios to contemplate the company’s next steps to increase profits and overcome setbacks.
- Investors can use this ratio to figure out the overall profitability of businesses that earn their highest profits in a particular season.
- A higher profitability ratio indicates the business is working efficiently in cash flow, revenue and profits.
- These ratios help business owners make budget-related decisions.
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What are the Different Types of Profitability Ratios?
The different types of profitability ratios are given below:
1. Operating Profit Margin
The operating profit margin allows you to measure a company’s earnings capacity after taking into account its current operating expenses. This calculation is done without considering the company’s interest and tax deductions.
If the resultant ratio is high, the company works efficiently to generate sales and earn enough profit. It also implies that the company is prepared to handle economic obstacles, interests and other fixed costs.
Operating profit ratios vary from one industry to another. Therefore, you can use the operating profit margin ratio to make comparisons between companies within the same industry.
2. Gross Profit Margin
This ratio evaluates a company’s profits after deducting the costs of goods and services and direct costs. A company that is efficient in earning a high net profit will have a high gross profit margin.
A company with a low gross profit margin means it is making very low profits. This can happen due to many factors like an unfavourable market, low sales and high production costs.
The gross profit ratio formula is given below:
3. Net Profit Margin
The net profit margin ratio is essential to know about the company’s financial health. It calculates a company’s total earnings from sales after deducting taxes, interests and other expenses. These include both operating and non-operating (direct and indirect) expenses.
When a company has a higher net profit margin ratio, it is efficiently managing its costs and other expenses.
Tracking the net profit margin ratio over time might help a company to analyse the working of new strategies. It can also help to spot the loopholes and make changes in approach to increase profit.
Companies within the same industry can use the net profit ratio to ascertain their progress among their peers and competitors.
4. Return on Assets (ROA)
Return of asset focuses on profits a company generates against every rupee of its total assets.
If there is a high ROA, it means a company is thoroughly efficient in managing its assets to generate profits. This ratio also assesses how asset-intensive a company’s business model is.
5. Return on Capital Employed (ROCE)
This measures a company’s overall returns for the overall investments of that company’s bondholders and shareholders.
It is one of the most used metrics by investors to decide whether or not these companies are worthy investments. They usually prefer a high ROCE, which indicates quantitative profit against assets.
6. Return on Equity (ROE)
ROE reflects how a company manages its money which was invested by shareholders. If the company addresses these finances well, it will receive a high return on equity. This ratio indicates returns on the amount invested by these shareholders and investors.
Shareholders watch out for a high ROE before buying a company’s stocks. A company that thrives on a high return on equity does not need to depend on debt financing. This is because such companies are generating a lot of liquid cash themselves.
How to Calculate Profitability Ratio?
Let’s follow a simple example to understand the working profitability ratio.
A is a clothing company with a total equity capital of Rs.12 crore. As the financial year ends, the total assets of this company become Rs.45 lakh while its current liability is Rs.8 lakh.
Find below the income statement of Company A:
Total sales = Rs.5,00,000
Cost of goods sold= Rs.1,30,000
Gross profits= Rs.3,70,000
Salary expense= Rs.10,000
Interest= Rs.10,000
Operating expense= Rs.1,70,000
Taxes= Rs.4,000
Depreciation= Rs.25,000
Net profit= Rs.1,51,000
Now let’s calculate the profitability ratio as per the above information
1. Gross Profit Margin
The gross profit ratio formula is given below.
Gross profit margin= gross profit/net sales
Gross profit = net sales-cost of goods sold
= 5, 00,000 – 1,30,000
= 3,70,000
Gross profit margin= (3,70,000/5,00,000)*100
Gross profit margin ratio = 74%
2. Net Profit Margin
The Net profit ratio formula = net profit/sales*100
Net profit margin = (1,51,000/5,00,000)*100
= 30.2%
3. Operating Profit Margin
The Operating profit ratio formula= operating profit/ net sales
Operating profit = gross profit-operating expenses-depreciation
= 3,70,000-1,70,000-2500 = 1,75,000
= 1,75,000/5,00,000*100
Therefore, operating profit margin= 35%
4. Return on Capital Employed
ROCE= EBIT/ Capital employed
EBIT= 1,51,000-10,000-4,000= Rs. 1,65,000
Capital employed = 45,00,000-8,00,000 = Rs. 37,00,000
ROCE =1,65,000/37,00,000*100
ROCE= 4.08%
5. Return on Equity
Return on equity formula = net profit after taxes/ shareholder’s equity
ROE= 1,51,000/1,20,00,000*100
ROE= 1.25%
6. Return on Assets
Return on Assets formula= net profit after taxes/total asset
ROA= 1,51,000/45,00,000*100
ROA= 3.35%
How to Interpret Profitability Ratios?
Here are some ways you can use profitability ratios to determine your company’s standing and financial health.
1. Gross Margin
A company with a high gross margin implies a good position among its target audiences. It also highlights that this company charges premium prices for its products. On the other hand, a lower gross margin can mean product prices are very low or direct cost is too high.
However, this may vary from one industry to another. For instance, a company with a varied product mix can have a low gross margin. Therefore, you should not compare such companies’ gross margins with rivals with fewer product mixes.
Along with the gross margin, a company should pay attention to its operating margin. If its operating margin is low, even with a high gross margin, this indicates it has too high expenses.
2. Net Margin
A healthy net margin implies that the company manages its expenses and non-operational finances well. On the other hand, a poor net margin suggests the company is generating low incomes and paying interest on debts.
3. Seasonal Businesses
Many companies find that their net sales vary from season to season. In such cases, studying their net margins for a peak season for a course of time can help gain insight. You can assess how far your company has developed or sectors that need special attention. This will ensure your business soars high.
4. Competitor Analysis
A similar industry can sustain both large and small-scale firms. However, comparing the revenues of each firm will not help you to gain insight for improving your business.
It is here profitability ratios come in handy. These ratios allow large and small businesses to measure their status in terms of profit and efficiency. This will further help them plan a strategy to beat their rivals.
Limitations of Profitability Ratios
Like every other metric, profitability ratios are not flawless. Here are a few important limitations of probability ratios to keep in mind.
- A method error or fraud will result in providing wrong ratios to the investors. This may cause misjudgement amongst investors.
- There are high chances of manipulation of data by the management of companies. Tweaked data can result in a false picture and dope investors on investing lump sum money in these industries.
- Probability ratios can only say how your company works now based on its past data. These metrics do not have any power to predict the future. Financial analysts perform deeper research to predict the future performance of a company.
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Final Word
As you see, understanding profitability ratiosare necessary for investors and a company’s management to interpret its earnings. In addition, this tells about the company’s present standing and provides insights on how it can plan its future strategies to attract more investors.
FAQs
Ans: This category of profitability ratios represents a company’s capability to turn sales into profits.
Ans: These ratios demonstrate a company’s capability to generate returns for owners and investors.
Ans: Profitability ratios allow companies to seek investors’ attention. If investors observe that a company is making good profits, they will willingly invest their money in the company.
Ans: A company can increase its profit generation by reducing costs and improving the price and production of goods.
Ans: Factors such as demand, competition, economy, relative costs and advertising tend to affect the probability ratio of a company.
Disclaimer
This article is solely for educational purposes. Navi doesn't take any responsibility for the information or claims made in the blog.
