What is Profitability Ratio? Different Types of Profitability Ratios
What is Profitability Ratio?
Most organizations need to take a close look at their financial position. One might carry out such activity in response to an expansion project, insufficient cash in hand, or an increase in expenses. Examining the financial ratios carefully is one approach to assessing your financial situation and determining what may be done to make it better.
Ratios are used to compare various aspects of a firm's performance or how the company performs within a specific industry or geographic area. They make fairly fundamental revelations about the business, such as if they have too much debt, too much inventory, or are not collecting receivables quickly enough.
Some industries have operations that are seasonal. For instance, during the year-end holiday season, shops often see much greater revenues and earnings. Therefore, since they are not directly comparable, it would be useless to compare a retailer's fourth-quarter gross profit margin to its first-quarter gross profit margin. It would be significantly more insightful to compare a retailer's fourth-quarter profit margin to its fourth-quarter profit margin from the previous year.
Profitability ratios are a group of financial indicators that are used to evaluate a company's capacity to create earnings compared to its sales, operational costs, balance sheet assets, or shareholders' equity over time. The ratios, although generally the higher the more favorable, provide a more clear idea of the company’s standing when compared with competing companies, own historical figures, or industry average.
Overall profitability ratios are based on evaluating how well a company is using its resources to generate returns and meet shareholders’ expectations. A lot of investors use profitability ratios to assess a company’s performance with respect to its return on investment. Internally the company uses these ratios to judge company performance and uses it to make necessary changes to ensure better utilization of resources.
Types of Profitability Ratios
Profitability ratios include Gross Profit Margin, Operating Profit Margin, Net Profit Margin, Return on Equity (ROE), Return on Assets (ROA), and Return on Capital Employed (ROCE). The usage and significance of these profitability ratio types are discussed below:
Gross Profit Margin
The gross profit ratio calculates the amount of income that is left after deducting the cost of goods sold. A large gross margin is essential since it will enable a company to generate a higher net profit. Higher gross profit margins indicate that the company is able to cover expenses like fixed costs, operating expenses, depreciation, etc. and is able to generate income over and above these expenses, whereas, a low gross profit margin is an indicator of poor performance by the company possibly because of low sales, high production costs, unfavorable market scenario, etc.
Formula:
Gross Profit Margin = Gross Profit / Net Sales
Here, Gross Profit = Net Sales (Total Sales - Allowances - Discount - Sales Return) - Cost of Goods Sold
Operating Profit Margin
The operating profit margin represents the percentage of profit that a company earns out of the total revenue before deducting the interest and taxes. This reflects a true image of the efficiency of the operations of the company. The ratio differs across different industries and is used as a measure to evaluate company performance against other companies within the same industry. It can also be used as a measure to assess the performance of a company with others and point out the need for development in a particular field for better efficiency within the company.
Formula:
Operating Profit Margin = Operating Profit / Net Sales
Here, Operating Profit = Gross Profit - Operating Expenses - Depreciation and Amortization
Net Profit Margin
Net Profit Margin reflects the amount that gets converted as net profit out of each rupee of revenue collected by the company. It is one of the most important indicators of the financial health of a company. By tracking changes in the net profit margin, during different time periods a company can assess the performance of new strategies or workflows and initiate the ones that prove to be favorable. This ratio can be compared with industry standards in order to ascertain a company's performance against its competition.
Formula:
Net Profit Margin = Net Profit / Net Sales
Here, Net Profit = Gross Profit - Operating and Other Expenses - Interest - Taxes
Return on Equity (ROE)
This ratio is a reflection of the company’s performance in terms of how well it is managing the money that has been invested into it by the shareholders. In other words, it is the measure of the amount of income that it generates per rupee of equity invested by shareholders. The higher the return on equity, the better the company is at managing to generate returns on its equity financing. This formula proves to be especially useful when comparing businesses in the same industry as it provides a clear understanding of the financial efficiency and the efficiency of utilizing primarily tangible resources instead of intangible ones.
Formula:
Return on Equity (ROE) = Net Profit / Shareholder’s Equity
Here, Net Profit = Gross Profit - Operating and Other Expenses - Interest - Taxes
Return on Assets (ROA)
Profit to revenue ratios are a helpful operational metric, but the viability of a company's survival is indicated by comparing profits to the resources it utilizes to generate them. The simplest of these corporate efficiency metrics is the return on assets. This ratio assesses how profitable the company is with respect to the assets it uses to generate profits. The higher the ROA the higher the efficiency of the company to manage its balance sheets and generate profits whereas, a lower ROA indicates scope for improvement.
Formula:
Return on Assets (ROA) = Net Profit / Total Assets
Here, Net Profit = Gross Profit - Operating and Other Expenses - Interest - Taxes
Return on Capital Employed (ROCE)
The profitability ratio known as return on capital employed (ROCE) assesses how effectively a business uses its capital to produce profits. Investors frequently use the return on a capital-employed measure to decide whether or not a company is a good investment. It is regarded as one of the finest profitability ratios. The return on capital employed measures the operating income produced per dollar of invested capital. A higher ROCE is usually preferable because it shows that far more profits are made for every dollar of invested capital.
Formula:
Return on Capital Employed (ROCE) = Net Profit / Capital Employed
Here, Net Profit = Gross Profit - Operating and Other Expenses - Interest - Taxes
Capital Employed = Total Assets - Current Liabilities
How to Calculate Profitability Ratios?
To understand how the above-discussed ratios are calculated, let us take an example of XYZ Ltd. The table below contains all the necessary details about the company’s financials.
| Particulars | Amount (Rs.) |
| Net Sales | ₹800,000 |
| Cost of Goods Sold | ₹360,000 |
| Gross Profit | ₹440,000 |
| Salary Expense | ₹120,000 |
| Operating Expenses | ₹95,000 |
| Interest | ₹12,000 |
| Depreciation | ₹25,000 |
| Taxes | ₹8,000 |
| Net Profit | ₹180,000 |
| Shareholder's Fund | ₹3,000,000 |
| Total Assets | ₹7,500,000 |
| Current Liabilities | ₹2,500,000 |
Profitability Ratio Formulas:
Gross Profit Margin
= Gross Profit / Net Sales
= 440,000 / 800,000
= 0.55 or 55%
Operating Profit Margin
= Operating Profit / Net Sales
= (Gross Profit - Operating Expenses - Depreciation and Amortization) / Net Sales
= (440,000 - 95,000 - 25,000) / 800,000
= 320,000 / 800,000
= 0.4 or 40%
Net Profit Margin
= Net Profit / Net Sales
= (Gross Profit - Operating and Other Expenses - Interest - Taxes) / Net Sales
= (440,000 - 120,000 - 95,000 - 25,000 - 12,000 - 8,000) / 800,000
= 180,000 / 800,000
= 0.225 or 22.5%
Return on Equity
= Net Profit / Shareholder’s Equity
= 180,000 / 3,000,000
= 0.06 or 6%
Return on Assets
= Net Profit / Total Assets
= 180,000 / 7,500,000
= 0.024 or 2.4%
Return on Capital Employed
= Net Profit / Capital Employed
= Net Profit / (Total Assets - Current Liabilities)
= 180,000 / (7,500,000 - 2,500,000)
= 180,000 / 5,000,000
= 0.036 or 3.6%
The above-calculated ratios can be used for internal company performance assessment and peer comparisons. Further, these ratios help investors make their investing decisions.
What is the best profitability measure?
The best profitability measure is the Net Profit Margin, as it reflects an aggregate performance metric for the business. It takes into consideration the amount of take home profit that the business generates and the amount of revenue collected to make this profit.
Which key performance indicator is the most important for measuring profitability?
The revenue per hour is considered the most important metric when a business needs to assess its profitability. This metric takes into consideration the amount of revenue that the business generates in an hour on average to get an idea of how efficiently the resources are being managed and utilized.
Who uses the profitability ratios?
These ratios are used by various stakeholders, for example, business managers use them to assess the performance and bring in changes to improve efficiency, and shareholders use them to evaluate the performance and plan their investment decisions accordingly.