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.
The Gross Profit Ratio, also known as the Gross Margin Ratio, measures a business’s performance and efficiency. This ratio compares a company’s gross profit to its revenue, indicating how well it controls production costs relative to its sales.The gross profit ratio also 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.
Formula:
GP ratio= Gross profit figure ÷Total net sales
Key Insights:
The Operating Ratio compares a company’s operating expenses to its net sales. It evaluates the efficiency of a company in managing its operating costs relative to its revenue.
Formula:
Operating ratio = (operating expenses + cost of goods sold) ÷ net sales
Interpretation:
The Operating Profit Ratio, or Operating Margin, reflects the relationship between a company’s operating profit and its revenue.
Formula:
Operating Profit Ratio = Operating profit / Net sales × 100
Where, operating Profit = Total revenue – (Cost of revenue + Research & Development + Sales, general, and admin. expenses)
The Net Profit Ratio, or Net Profit Margin, measures a company’s profitability after taxes and all expenses. It shows how much net profit is generated per dollar of revenue.
Formula:
Net profit margin ratio = Net profit ÷ Total Revenue
Key Insights:
ROI evaluates the profitability of an investment by comparing its net gain or loss to its cost. It is a widely used metric for assessing investment efficiency.
Formula:
Return on Investments (ROI) = (Net return ÷ Original cost of investment) ×100
Interpretation:
Return on Net Worth assesses a company’s ability to generate profit for its shareholders by comparing net income to shareholders’ equity.
Formula:
RoNW = Net income / Shareholders’ equity
EPS measures the profitability attributable to each outstanding share of common stock. It is a key indicator of a company’s financial health.
Formula:
EPS = (Net Income – Preferred Dividends) ÷ Weighted Average Shares Outstanding.
Or
*EPS = (Net Income – Preferred Dividends) ÷ Shares Outstanding at the end of the period
*Note: EPS is calculated using the total number of outstanding shares, but Analysts often use the weighted average number of shares to account for fluctuations during the period.
BVPS indicates the net asset value of a company per share. It is derived from the company’s equity as recorded in the balance sheet.
Formula:
Book value per Share = Common equity of the company ÷ Number of shares outstanding
Where, Book value = Total Assets – Total Liabilities
The Dividend Payout Ratio reflects the proportion of earnings distributed as dividends to shareholders.
Formula:
DPR = (Dividends paid ÷ Net earnings) ×100
The P/E Ratio compares a company’s current share price to its earnings per share. It helps investors determine whether a stock is overvalued or undervalued.
Formula:
P/E Ratio = (Current Market Price of a Share÷ Earnings per Share)
Key Insights:
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.
The term “return” in the Return on Assets (ROA) ratio, also known as Net Profit to Total Assets, typically refers to net profit or net income—the earnings from sales after all costs, expenses, and taxes have been deducted. The more assets a company holds, the greater its potential to generate sales and profits. Economies of scale can lower costs and improve margins, allowing returns to grow faster than assets, ultimately enhancing the ROA.
Formula:
ROA = Net Profit ÷ Total Assets
(Net Profit = Gross Profit + Indirect Income – Indirect Expenses)
Annual net profit (before tax) divided by total assets yields the ROA. Also referred to as the Return on Total Assets (ROTA), this ratio reflects the return rate on business investments. It serves as a measure of whether a firm’s efficiency is improving or declining. A 10% to 20% ROA is desirable, while anything above 7% is acceptable.
The Net Profit on Net Sales ratio, also called the net profit percentage or net profit margin, measures after-tax profits relative to net sales. It indicates the residual profit after deducting production, administrative, and financing costs, as well as income taxes.
Formula:
Net Profit Margin = (Net Profit ÷ Net Sales) × 100
For this ratio, net profit equals gross profit minus operating expenses and income tax. Non-operating revenues and expenses are excluded to focus on profitability from core operations. A higher ratio indicates stronger profitability. A 20% return on turnover is desirable, 10% is satisfactory, and 5% is tolerable.
Gross Profit on Net Sales measures management’s pricing efficiency and tracks profitability across different periods. Changes in this ratio may result from factors like increased expenses, declining product prices, reduced production, or variations in wages and freight costs.
Formula:
Gross Profit Margin = (Gross Profit ÷ Net Sales) × 100
The Cash Flow Margin Ratio is a key profitability measure that evaluates how effectively a business generates cash from sales operations.
Formula:
Cash Flow Margin = Cash Flows from Operating Activities ÷ Net Sales
A higher cash flow margin indicates efficient debt collection and strong earnings quality.
The Profit Volume (P/V) Ratio measures how profit changes in response to changes in sales volume.
Formula:
P/V Ratio = (Contribution × 100) ÷ Sales
(Contribution = Sales Price – Variable Cost)
(*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
By understanding and applying these profitability ratios, businesses and investors can gain valuable insights into financial health, operational efficiency, and potential areas for improvement.
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