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There are different financial metrics that help measure the success of a business. Profitability ratios are one of the key metrics that help to monitor the overall financial efficiency and health of the business. Also, these metrics help the management assess its ability to generate earnings and the improvement areas. This article will discuss profitability ratio, their types, interpretation, and calculations.
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What are Profitability Ratios?
Profitability ratios are financial metrics that help to measure and also evaluate the ability of a company to generate profits. Also, these abilities can be assessed through the income statement, balance sheet, shareholder’s equity or sales processes for a specific time period. Furthermore, the profitability ratio indicates how well the company utilises its assets to generate profits and provide value to its shareholders.
The profitability ratio is also an effective way to analyse and compare similar companies or previous periods. Hence, any company aims for a higher ratio, indicating that the business is performing well in revenue, profits, or cash flow. Also, most investors and creditors use profitability ratios to analyse the company’s return on investment to its relative level of resources and assets. Furthermore, company management also analyses these ratios to increase profitability by making the necessary improvements within the business operations.
Types of Profitability Ratios
- Gross Profit Margin
- Operating Profit Margin
- Net Profit Margin
- Return on Equity (ROE)
- Return on Assets (ROA)
- Return on Capital Employed ()
Gross Profit Margin
The gross profit margin ratio helps measure how much profit a company generates from its sales of goods and services after deducting direct costs or the cost of goods sold. Also, a higher gross profit is a positive indication that the company can cover operating expenses, fixed costs, depreciation, etc., and generate net income for the company. In contrast, a low gross profit margin reflects poorly on the company, indicating high selling price, low sales, high costs, severe market competition etc.
Formula
Gross Profit Margin = Gross Profit / Net Sales
Where,
Gross Profit = Net Sales – Cost of Goods Sold
Net Sales = Total Sales – Discounts – Allowances – Sales Returns
Operating Profit Margin
Operating Profit Margin helps measure the company’s ability to maintain operating expenses to generate profit before interest expense and tax deduction. In other words, the revenue that remains after costs is deducted from net sales. A higher ratio indicates that the company is well equipped to pay its fixed costs, interest obligations, handle economic slowdowns and also offer lower prices than its competitors at lower margins. Moreover, the company management most frequently uses this to improve profitability by managing its costs.
Formula
Operating Profit Margin Ratio = Operating Profit / Net Sales
Where,
Operating Profit = Gross Profit – Operating Expenses – Depreciation and Amortisation
Net Sales = Total Sales – Discounts – Allowances – Sales Returns
Net Profit Margin
The net profit margin measures the company’s overall profitability from its sales after deducting all direct and indirect expenses. Also, it is the percentage of revenue that remains after deducting all expenses, interest and taxes. A higher net profit indicates that the company is operating well while managing its costs and pricing of goods and services. However, one drawback of using this ratio is that it includes one time expenses and gains, making it challenging to compare performance with its competitors.
Formula
Net Profit Margin Ratio = Net Income / Net Sales
Where,
Net Income = Gross Profit – All Expenses – Interest – Taxes
Net Sales = Total Sales – Discounts – Allowances – Sales Returns
Return on Equity (ROE)
ROE measures how well a company can use its shareholders’ money to generate profits. Also, it indicates the returns on the sum of money the investors have invested in the company. Furthermore, ROE is usually watched by investors and analysts. Moreover, a higher ROE ratio can be one of the reasons to buy a company’s stock. Companies with a high return on equity can generate cash internally, and thus they will be less dependent on debt financing.
Formula
Return on Equity = Net Profit after Taxes / Shareholder’s Equity x 100
Where,
Shareholder’s Equity = Equity Share Capital
Return on Assets (ROA)
Return on Assets (ROA) measures how well a company uses its assets to generate profits. In other words, it focuses on how much profit it generates on every rupee invested. Also, it measures the asset intensity of the company. Thus, a lower ROA indicates a more asset-intensive company. On the contrary, a higher ROA indicates more profitability against the company’s number of assets to operate. Moreover, companies with higher asset intensity must invest a significant amount in machinery and equipment to generate income. For example – telecommunication, car manufacturers, railroads, etc.
Formula
Return on Assets = Net Profit after Taxes / Total Assets x 100
Where,
Total assets = All the assets on the balance sheet
Return on Capital Employed (ROCE)
Return on Capital Employed (ROCE) measures the company’s overall return against the overall investment of both shareholders and bondholders. This ratio is very similar to ROE, but it is more comprehensive as it includes the returns generated from bondholders capital investments.
Formula
Return on Capital Employed (ROCE) = EBIT / Capital Employed
Where,
EBIT (Earnings Before Interest & Taxes) = Net Profit Before Interest and Taxes
Capital Employed = Total Assets – Current Liabilities
How to Calculate Profitability Ratios?
The profitability ratio is also a financial metric to measure if a company has a healthy profit margin. Also, you can calculate these ratios consistently and track the profitability over time. Let us understand the calculation of profitability ratios with the following example.
Company ABC ltd manufactures customised skates where the total equity capital is Rs 12 crores. At the end of the financial year, the total assets are Rs 45 lakhs and also current liabilities is Rs 8 lakhs, and the income statement looks like below –
| Particulars | Amount (Rs.) |
| Total Sales | 500,000 |
| Cost of Goods Sold | 130,000 |
| Gross Profit | 370,000 |
| Salary Expense | 10,000 |
| Operating Expenses | 170,000 |
| Interest | 10,000 |
| Depreciation | 25000 |
| Taxes | 4000 |
| Net Profit | 151,000 |
The following table shows the calculation of the profitability ratios:
| Ratio | Formula | Calculation | Result |
| Gross Profit Margin | Gross Profit Margin = Gross Profit / Net Sales | = 430,000 / 500,000 | 74% |
| Operating Profit Margin | Operating Profit Margin Ratio = Operating Profit / Net Sales Operating Profit = Gross Profit – Operating Expenses – Depreciation | Operating Profit = 370,000 – 170,000 – 25000 = 175,000 OPM = 175,000 / 500,000 | 35% |
| Net Profit Margin | Net Profit Margin Ratio = Net Income / Net Sales | = 151,000 / 500,000 | 30.2% |
| Return on Equity | ROE = Net Profit after Taxes / Shareholder’s Equity | = 151,000 / 1,20,00,000 | 1.25% |
| Return on Assets | ROA = Net Profit after Taxes / Total Assets | = 151,000 / 45,00,000 | 3.35% |
| Return on Capital Employed | ROCE = EBIT / Capital Employed | EBIT = 151,000 – 10,000 – 4000 = 165,000 ROCE = 165,000 / (45,00,000 – 800,000) | 4.08% |
Using the above ratios, you can analyse the company’s performance and also do a peer comparison. Furthermore, these ratios will help you evaluate if a company is worth investing in. Therefore, carefully consider all the profitability ratios and take informed decisions.
Recommended Read: What is Portfolio Turnover Ratio?
Interpretation of Profitability Ratios
Every company aims for making a profit. As a shareholder, it is also essential to review the company’s financial performance by interpreting the profitability ratios –
High or Low Gross Margin.
If a company has a higher gross margin, it indicates that it charges premium prices for its products or its direct cost is low and thus making it well-positioned in the market. On the other hand, a lower gross margin can indicate weak pricing or high direct costs. However, the company’s mix of products may be changing, where they can have a lower gross margin.
Even though the gross margin is attractive but the operating margin is low, the company is spending too much money on fixed expenses. For instance – rising rents, higher salaries to employees, etc.
High or Low Net Margin
A company with a strong net margin manages operating expenses as well as its non-operating expenses very well. A lower net margin may be due to low income by paying interest expenses on debt incurred. However, debt on a company’s balance sheet is not bad if the interest is low and the company cash flows are sufficient to afford interest payments.
Comparing with Competitors
If the competitors are more established than a small business, a revenue comparison is not relevant and helpful. Instead, comparing the profitability ratios gives insight to the small businesses on how they can measure in terms of efficiency and profit, which is more helpful.
Revealing Problems within the Company
Studying the financial statements, including the balance sheets and income statements, can also reveal the big picture of the company. However, assessing profitability ratios allows investigating the various areas of business problems like rising costs of goods sold. Further, the management can work towards improving these problems efficiently.
Assessing Seasonal Business
Companies whose net sales revenue vary from one season to another can benefit from using profitability ratios. Also, comparing the company’s historical performance and earnings over the same quarters for several years helps company management with budget analysis and strategic planning decisions.
Attracting Investors
Investors study the company before they make any investments. As a result, profitability ratios provide investors with data to make well-informed investment decisions.
Summary
Profitability ratios help assess the company’s performance by calculating the profitability at different levels, i.e. gross, profit after taxes (PAT) and EBITDA. Also, it measures the company’s abilities through balance sheets, sales processes or shareholder’s equity. Furthermore, assessing them periodically helps improve the areas where companies need attention. Moreover, investors can compare these ratios of companies within the same industry before investing in them. However, they cannot be used to compare companies of different sectors as they may vary widely. Therefore, analysing the profitability ratio helps investors and management to make well-informed decisions.
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