Profitability ratio is a financial metric used to assess the strength of a business. To understand more about profitability ratios you can read the article below!
Understanding profitability ratios
Profitability ratios are a class of financial metrics used to assess a business's ability to generate earnings relative to revenues, operating expenses, balance sheet assets, or shareholders' equity over time, using data from a specific point in time. Profitability ratios can be contrasted with efficiency ratios, which consider how well a company is using its assets internally to generate earnings (as opposed to profit after expenses).
Types of profitability ratios
There are various profitability ratios used by companies to provide useful insights into the financial well-being and performance of the business. All these ratios can be generalized into two categories, as follows:
A. Margin Ratio
Margin ratios represent a company's ability to convert sales into profits at various levels of measurement. Examples include gross profit margin, operating profit margin, net profit margin, cash flow margin, EBIT, EBITDA, EBITDAR, NOPAT, operating expense ratio, and overhead ratio.
B. Return Ratio
Return ratios represent a company's ability to generate returns for its shareholders. Examples include return on assets, return on equity, cash return on assets, return on debt, return on retained earnings, return on revenue, risk-adjusted return, return on invested capital, and return on capital employed.
Profitability ratio function
Profitability ratios are financial metrics used by business owners, accountants, investors, and creditors to evaluate the financial health of a business. Profitability ratios can provide information such as how well a business is generating revenue, if operating expenses need to be reduced, and how efficiently the business is generating income from existing assets and/or investors. These financial ratios also provide stakeholders with a way to track financial trends over an extended period. In most cases, a higher ratio is a reliable indicator that a business is performing well. However, it is important to remember that profitability ratios should always be used consistently to better identify trends and make any changes if necessary. Companies typically use two categories of profitability ratios or financial ratios for analysis: profit margin ratios such as gross profit and net profit margin, and return ratios such as return on equity. These two categories of ratios provide a more complete picture of the business. Calculating these ratios can also help answer the following questions:
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- Is your business performance trending up or down?
- Can your business generate enough revenue to cover expenses?
- What are the weak areas of your business?
- How does your business compare to other similar businesses?
- Is your current business a good investment?
What Are the Three Key Profitability Ratios?
Profitability ratios can be classified into three types. These are operating profitability, asset utilization and contribution. Business performance profitability ratios focus on the revenue generated by a company. They provide information on what portion of sales revenue is available for expenses. This is an important figure in your expense ratio. This is after all the costs of producing the goods sold have been deducted from the total revenue.
Operating Profitability Ratio
This profit ratio determines how well a company is able to generate sales revenue. This is after deducting the cost of goods sold. The operating profitability ratio can be calculated as follows. Divide net income by sales. Operating Profitability Ratio = Net Profit/Sales
Asset Utilization Profitability Ratio
Asset utilization ratios focus on assets. These include total assets and fixed assets. These are used to generate sales revenue. They are calculated after all operating expenses have been deducted from revenue. There are two types of asset utilization profitability ratios. These are the fixed asset turnover ratio and the inventory turnover rate.
- Fixed Asset Turnover Ratio. This measures how effectively a company is using its fixed assets. It is calculated by dividing total revenue by total fixed assets.
- Inventory Turnover Rate. The inventory turnover rate measures how effectively a company is using its inventory. It is calculated by dividing net sales revenue by average inventory.
Contribution Profitability Ratio
The contribution margin ratio helps companies measure the effectiveness of their marketing efforts. Contribution margin is also known as gross profit or revenue minus cost of goods sold. It is what is left over after subtracting cost of goods sold from total revenue. Contribution Margin = Revenue - Cost of Goods Sold/Revenue Divide net income by contribution margin to get the contribution margin ratio. This will tell you how much is available to be distributed as dividends per share.
Profitability Ratio Example
Profitability ratios are among the most popular metrics used in financial analysis, and generally fall into two categories—margin ratios and return ratios. Margin ratios provide insight, from several different angles, into a company’s ability to convert sales into profits. Return ratios offer several different ways to examine how well a company is generating returns for its shareholders. Some common examples of profitability ratios are various measures of profit margin, return on assets (ROA), and return on equity (ROE). Others include return on invested capital (ROIC) and return on capital employed (ROCE).
Profit Margin
Different profit margins are used to measure a company’s profitability at different levels of cost of investigation, including gross margin, operating margin, pre-tax margin, and net profit margin. Margins shrink as additional layers of costs are taken into account—such as COGS, operating expenses, and taxes. Gross margin measures how much a company makes after accounting for COGS. Operating margin is the percentage of sales that remains after covering COGS and operating expenses. Pre-tax margin shows a company’s profitability after accounting for further non-operating expenses. Net profit margin is a company’s ability to generate revenue after all expenses and taxes.
Return on Assets (ROA)
Profitability is assessed relative to costs and expenses and analyzed against assets to see how effectively a company is using assets to generate sales and profits. The term “return” in the ROA measure usually refers to net income or net profit—the value of revenue from sales after all costs, expenses, and taxes. ROA is net income divided by total assets. The more assets a company accumulates, the more sales and potential profits it can generate. Because economies of scale help lower costs and increase margins, returns can grow at a faster rate than assets, ultimately increasing ROA.
Return on Equity (ROE)
ROE is a key ratio for shareholders because it measures a company's ability to earn a return on its equity investment. ROE, calculated as net income divided by shareholders' equity, can increase without additional equity investment. This ratio can increase because higher net income is generated from a larger asset base funded with debt. That's the explanation of profitability margin, you can also read other GIC articles to get more knowledge, such as the explanation of Black Card, only in the GIC Journal. Make sure to download the GIC Mobile Apps on the Google Play Store and the Apple App Store. Don't forget to register for trading at GIC to try to start having digital assets.
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