What are profitability ratios?

Profitability ratios help a business entity as well as the lenders/investors to evaluate the ability to generate income as compared to its expenses and other cost associated with generation of income during a particular period. Profitability Ratios also help the managements in making business decision in respect of expansion or diversification of the business.  As said before, the profitability is assessed relative to costs and expenses, and it is analyzed in comparison to assets to see how effective a company is in deploying assets to generate sales and eventually profits.

The profitability ratios are generally expressed in terms of percentage. Examples of key profitability ratios are  ‘Return on Equity’ (Net profit on tangible Net worth), Return on Assets (Net profit to total assets)  ‘Net profit on net sales’, ‘Gross profit to net sales’, Gross profit ratio,  Cash Flow Margin Ratio, Profit Volume ratio  etc.

1. Return on Equity:

Return on Equity or Net profit on Tangible Net Worth ratio provides percentage of return on own capital.  ROE ratio is a ratio that concerns a company’s equity holders the most, since it measures their ability of earning return on their equity investments.

Formula: Profit after Tax ÷ Net worth*

* (Net worth = Equity share capital, and Reserve and Surplus)

Division of net profit (after tax) by tangible net worth multiplied by 100 is the ‘Net Profit on Tangible Net worth Ratio’.

A high ratio represents better the company.

2. Return on Assets:

The term return in the ROA ratio or Net Profit to Total Assets customarily refers to net profit or net income, the amount of earnings from sales after all costs, expenses, and taxes. The more assets a company has amassed, the more sales and potentially more profits the company may generate. As economies of scale help lower costs and improve margins, returns may grow at a faster rate than assets, ultimately increasing the return on assets.

Net Profit to Total Assets   =      Net Profit* ÷ Total Assets                                                                      

*(Net Profit means Gross Profit + Indirect Income – Indirect Expenses)

Annual net profit (before tax) is divided by total assets to obtain Net Profit to total assets. This ratio is also known as ‘Return on Total Assets (ROTA). It reflects the rate of return on investments made in business. This is another test to ascertain whether the efficiency of the firm is growing or declining. 10 to 20% return on assets is desirable. Above 7% is tolerable.

3. Net profit on Net sales:

The net profit percentage or net profit margin or Net profit on Net sales is the ratio of after-tax profits to net sales. It indicates the residual profit after all costs of production, administration, and financing have been deducted from sales, and provisions made for income taxes.

Net profit on net sales =    (Net profit ÷ Net sales) × 100        

For the purpose of this ratio, net profit is equal to gross profit minus operating expenses and income tax. All non-operating revenues and expenses are not taken into account because the purpose of this ratio is to evaluate the profitability of the business from its primary operations. A higher ratio means that the investment is rewarding. 20% return on turnover is desirable. 10% return is satisfactory. 5% is tolerable.

4. Gross profit on Net Sales:

Net annual gross profit is divided by net sales multiplied by 100 to get this ratio. This ratio provides a test of the management’s pricing policy compared to others in the business. The ratio is also used to measure profit earned between different periods. There may be several factors that contribute to changes in the ratio, namely, increase in expenses, fall in prices of the commodity produced, fall in production, variation in wages, freight, etc.

Gross profit on Net Sales = (Gross Profit ÷ Net Sales) ×100                                                                                               

5. Gross-Profit Ratio:

The gross-Profit ratio shows how efficiently a company utilizes its resources, materials, and labor to generate profit.

Gross-Profit ratio= gross profit ÷ total sales (revenue)

A higher Gross-Profit ratio indicates that the business is cost-effective. Moreover, the gross profit ratio helps in measuring manufacturing and distribution efficiency during the production process.  The investors compare the gross profit ratio of a company with its peers or in different industries.

6. Cash Flow Margin Ratio:

The Cash-Flow Margin ratio is an important profitability ratio that measures how well the business’s operations are creating cash from sales.

Cash flow margin = Cash flows from operating activities ÷ Net sales

Higher cash flow margin ratio reflects the efficiency of the company at debts collection and also a high earnings quality

7. Profit Volume Ratio:

The Profit Volume (P/V) Ratio is the measurement of the rate of change of profit due to change in volume of sales.

The PV ratio or P/V ratio is arrived at by using the following formula.

P/V ratio =contribution x100/sales

(*Contribution means the difference between the sale price and variable cost).

For the full details of PV ratio and how it helps to breakeven/desired sales etc. Click: P/V ratio

8. Operating Ratio or EBIT (Earnings Before Interest and Taxes):

EBIT measures a firm’s profits including all expenses except interest and income tax.    It represents earning power of the businesses from their ongoing operations

EBIT = Revenue – Operating Expenses

Or

EBIT = Net Income + Interest + Taxes

Related articles: