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.
Purpose and Importance
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 the profitability ratios. Management and investors calculate these ratios often and they are always present in the annual reports of the company. Since every business wants to generate profit and the investors also want returns on their investments, it is mandatory to showcase how the company is working and generating profit. Thus, profitability ratios analysis is an important evaluation criterion for companies.
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 lifeblood 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 of 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 are a bunch of financial metrics which measures the profit generated by the company and its performance over a period of time. The profit of the company which is assessed by these ratios can be simply defined or explained as the amount of revenue left after deducting all the expenses and losses which incurred in the similar time 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.
Gross Profit Margin
Net Profit Margin
It is the most common profitability ratio which is used to measure the profit after deducting all the expenses, losses, provisions for bad debt. It measures how much you are making out of every penny you spent 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. For an in-depth understanding of this ratio, visit Net Profit Margin.
Operating Profit Margin
This is the metric which is used to evaluate the operating efficiency of the company. EBIT i.e. earnings before interest and taxes are calculated to understand how much profit the company has generated from its core operation. Operating profit margin evaluates this EBIT as a percentage of sales to understand the efficiency of the operations of the company. For full coverage, read Operating Margin Ratio.
Expense ratios are a comparison of any particular type of expense with respect 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.
Return on Assets (ROA)
It is the profitability ratio which 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. 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 the insight into the company’s profit-generating ability to the investors. The potential, as well as 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, more favorable it is for the investors to invest in the company. Read exclusively about Return on Equity here.
Return on Capital Employed (ROCE)
This is a third ratio which covers the equity as well as debt part too. In place of equity capital, total capital employed is used as the denominator to calculate this ratio. Read a detailed write up about Return on Capital Employed here.
- Gross Profit Margin = (Gross profit / Net Sales )*100
- Net Profit Margin = (Net Profit / Net Sales)*100
- Operating Profit Margin = (Operating Profit / Net Sales)*100
- Expense Ratio = Expenses (Ex. Sales and Distribution) / Net Sales
- Return on Asset = ( Net Income / Assets)*100
- Return on Equity = (Net Income / Shareholder’s Equity Investment)*100
- Return on Capital Employed = Net Income / Capital Employed
Example with Calculation
Let us assume 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 of a business. It helps an analyst to 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 as well as its own past. These ratios are used by banks and financial institutions while lending to the business as the ratios ensure 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.
Uses of profitability ratios are different to 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 different aspects of a business and help the management to work more efficiently to generate more profits.