A profitability ratio may be simple for a finance specialist at a major organisation to grasp, but it can be more difficult for people embarking on a new business venture to grasp. In actuality, these calculations are rather simple. Furthermore, they are worth knowing because they can provide crucial information that can be used to expand a firm.
In this article, we’ll define a profitability ratio, the formula for profitability ratio, examples of profitability ratios, different types of profitability ratios and the most commonly used profitability ratio, including the gross margin.
What Exactly Are Profitability Ratios?
Profitability ratios are a type of financial indicator that assesses a company’s ability to create earnings compared to its revenue, operational costs, balance sheet assets, or shareholders’ equity over time, utilising data from a single moment in time. They are among the most widely used measures in financial research.
Profitability ratios can provide insight into a company’s financial performance and health. Ratios are best used as comparison aids rather than as standalone measurements.
Profitability ratios can be used in conjunction with efficiency ratios, which assess how successfully a company uses its assets internally to generate money (rather than after-cost profits).
What Kinds of Profitability Ratios Are There?
Companies utilise several profitability ratios to provide important insights into the financial well-being and success of the firm. All of these ratios fall into one of two categories:
#1. Ratios of Margin
Margin ratios, in varying degrees of measurement, show a company’s ability to transform revenues into profits. Gross profit margin, operational profit margin, net profit margin, cash flow margin, EBIT, EBITDA, EBITDAR, NOPAT, operating expense ratio, and overhead ratio are just a few examples.
#2. Ratios of Return
Return ratios show the ability of the company to generate returns for its owners.
Return on assets, return on equity, cash return on assets, return on debt, return on retained earnings, revenue, risk-adjusted return, return on invested capital, and return on capital employed are some examples.
What Are the Most Commonly Used Profitability Ratios, and What Do They Mean?
When analysing corporate productivity, most organisations use profitability ratios, which compare income to sales, assets, and equity. The following are six of the most commonly used profitability ratios:
#1. Gross Profit Margin
Gross profit margin measures how much of a profit is made on each sale. This indicates how much a company earns after deducting the costs of producing its goods and services. A high gross profit margin ratio indicates that core activities are more efficient, which means that they can still cover operating expenses, fixed costs, dividends, and depreciation while also generating net earnings for the organisation.
A low profit margin, on the other hand, shows a high cost of goods sold, which can be attributed to poor purchasing policies, low selling prices, low sales, severe market rivalry, or ineffective sales promotion techniques.
#2. EBITDA MarginÂ
EBITDA is an acronym that stands for Earnings Before Interest, Taxes, Depreciation, and Amortization. It indicates a company’s profitability before non-operating items such as interest and taxes, as well as non-cash factors such as depreciation and amortisation. The advantage of analysing a company’s EBITDA margin is that it allows for a simple comparison to other companies because it excludes expenses that may be erratic or somewhat discretionary.Â
The disadvantage of EBITDA margin is that it might differ significantly from net profit and actual cash flow generation, which are more accurate indications of firm performance. Many valuation methods make extensive use of EBITDA.
#3. Margin of Operating Profit
Operating profit margin – examines earnings as a proportion of sales before deducting interest and taxes. Companies with high operating profit margins are often better positioned to pay for fixed costs and interest on commitments, have a higher chance of surviving an economic slowdown, and can offer cheaper pricing than their competitors with lower profit margins. Operating profit margin is typically used to assess a company’s management strength since excellent management may significantly improve a company’s profitability by managing its operating costs.
#4. Gross Profit Margin
The bottom line is the net profit margin. It calculates net income by dividing it by total revenue. It presents the final picture of a company’s profitability after all expenses, including interest and taxes, have been deducted. The net profit margin is useful as a measure of profitability since it takes everything into account. One disadvantage of this metric is that it includes a lot of “noise,” such as one-time expenses and gains, making it difficult to compare a company’s performance to that of its competitors.
#5. Cash Flow Margin
The cash flow margin expresses the relationship between operating cash flows and sales generated by the business. It assesses a company’s capacity to convert sales into cash. The larger the percentage of cash flow, the more cash available from sales to pay suppliers, dividends, utilities, service debt, and capital assets. Negative cash flow, on the other hand, means that even if the company generates sales or profits, it may still be losing money.
In the case of a corporation with insufficient cash flow, the company may choose to borrow funds or acquire funds from investors to keep operations running. Managing cash flow is critical to a company’s success because having adequate cash flow both minimises expenses (e.g., avoiding late payment fees and extra interest expenses) and allows a company to take advantage of any extra profit or growth opportunities that may arise (e.g., the opportunity to purchase the inventory of a competitor who goes out of business at a substantial discount).
#6. Return on Investment
Return on assets (ROA) measures the percentage of net earnings relative to the total assets of a company. The ROA ratio expresses how much after-tax profit a company makes for every dollar of assets it owns. It also assesses a company’s asset intensity. The lower a company’s profit per dollar of assets, the more asset-intensive it is regarded as being.
To produce profitability, very asset-intensive businesses must make large investments in machinery and equipment. Telecommunications services, automobile manufacturers, and railroads are examples of asset-intensive sectors. Advertising firms and software companies are examples of less asset-intensive businesses.
#7. Return on Investment
Return on equity (ROE): the percentage of net income relative to stockholders’ equity or the rate of return on the money that equity investors have put into the business. Stock analysts and investors pay close attention to the ROE ratio. A high ROE ratio is frequently suggested as a motivation to buy a company’s shares. Companies with a high return on equity are typically better equipped to generate cash internally and hence, rely less on debt funding.
#8. Return on Capital Invested
Return on invested capital (ROIC) is a measurement of the earnings made by all capital providers, including bondholders and shareholders. It is comparable to the ROE ratio, but its scope is broader because it incorporates returns generated by bondholders’ money.
EBIT x (1-tax rate) / (value of debt + value of equity) is the simplified ROIC calculation. EBIT is used because it indicates earnings before deducting interest expenses and hence represents earnings available to all investors, not just shareholders.
The Formula for Profitability Ratio
The basis for calculating a profitability ratio is dividing a profit metric by revenue.
Profitability Ratio equation (%) = profit metric ÷ Net Revenue Metric
To convert the ratio to percentage form, multiply the resulting amount by 100.
Once standardised, the ratio can be used for comparison purposes, either to the company’s past performance or to its closest industry peers.
#1. Formula for Gross Margin Profitability Ratio
The gross margin profitability ratio compares a company’s revenue to its gross profit.
Because the gross profit indicator subtracts only one expense—the company’s cost of goods sold (COGS)—the gross margin ratio represents the percentage of revenue remaining after direct operational costs are deducted.
Gross Margin Profitability Ratio Equation (%) = Gross Profit / Net Revenue
The cost of goods sold (COGS) line item on the income statement is located directly below revenue (or sales) and indicates the direct costs incurred by a company to create revenue, such as direct materials and direct labour costs.
#2. The formula for EBIT Margin Ratio
The EBIT margin ratio, often known as the “operating profit margin,” compares an organization’s operating income to its revenue.
EBIT Margin profitability Ratio equation (%) = Operating Income minus Net Revenue
Operating income (EBIT) is a GAAP profitability measure computed by deducting operating expenses such as SG&A and R&D from gross profit. Running expenses, like COGS, are part of a company’s basic operations, i.e., the costs that must be incurred for the company to continue running.
The distinction, however, is that operating expenses are not directly tied to a company’s revenue generation process. As a result, the EBIT margin ratio shows the percentage of profits left after deducting both direct and indirect operating costs (COGS and OpEx) from sales.
#3. Formula for EBITDA Margin Ratio
The EBITDA margin ratio compares a company’s EBITDA to its sales at the same time.
EBITDA Margin Profitability Ratio Equation (%) = EBITDA ÷ Net Revenue
EBITDA, unlike EBIT, is a non-GAAP measure of profitability and hence does not appear on the income statement. Also, EBITDA, which is computed by adding depreciation and amortisation (D&A) to EBIT, is still by far the most generally used measure of profitability.
Depreciation and amortisation expenses are non-cash items, which means there is no actual cash movement associated with them.
#4. The Formula for Net Profit Margin Ratio
A company’s net profit margin ratio compares its net income to its revenue.
Net Profit Margin Profitability Ratio Equation (%) = Net Income ÷ Revenue
The net income measure (sometimes known as the “bottom line”) is the revenue remaining after deducting all operating and non-operating costs. In essence, the net profit margin ratio shows a company’s accrual-based profitability after deducting all costs, including non-operating costs and taxes.
Profitability Ratio Examples
Ratios can provide essential information for businesses and their stakeholders in calculating margins and returns and determining a company’s financial health. Here are a few real-world examples that demonstrate how these ratios function in practise:
#1. Example EBITDA
Scott’s Tots is a toy firm with a revenue of £200 million, production costs of £80 million, and operational costs of £25 million. The company’s amortisation and depreciation total £15 million, resulting in an operating profit of £80 million. Scott’s Tots’ interest expense is £5 million, leaving earnings before tax of £75 million.
After subtracting £15 million in taxes at a 20% tax rate, net income is £60 million. When depreciation, amortisation, interest, and taxes are deducted from Scott’s Tots’ net income, the EBITDA is £95 million. With that information, we can break down the company’s financials as follows: Net income: £60,000,000 Depreciation and amortisation: £15,000,000 Interest expenses: £5,000,000 Taxes: £15,000,000 EBITDA = £95,000,000
#2. Example of a Gross Margin Profitability Ratio
Wildfire Technology earns £30 million in revenue from application development, with £12 million going towards goods and services costs. Wildfire Technology’s profit is £30 million less £12 million in goods and services costs.
They may compute their gross margin by taking their £18 million gross profit and dividing it by £30 million, which equals 60%. Wildfire Technology earns 60p for every £1 in gross margin profit. The formula for determining the gross margin profitability ratio is as follows:
Gross margin profitability ratio = net sales minus cost of goods minus net sales, or 0.40, which equals £30 million minus £12 million minus £18 million.
#3. Return on Equity
Moolah Bank recorded a net income of £14 million during the third quarter, with shareholder equity of £58.17 million. ROE = net income/shareholder equity, or 24.06% = £14 million / £58.17 million. If the standard ROE for the banking industry is set at 20%, Moolah Bank has outperformed the industry average. As a result, shareholders can see that the bank is making a profit of 24p for every £1 it makes.
Limitations of Profitability Ratios
The following are some of the limitations of profitability ratios:
- Investment and profit values can be adjusted to increase or decrease profitability ratios, which can be misleading to investors and stakeholders.
- Errors in the various value calculations on a financial statement might result in misread ratios, which can be risky for investors and the organisation in the future.
- Ratios are not always 100% reliable because they can be high due to chance. To corroborate the findings, always analyse the context behind profitability KPIs.
Using Profit Margins in Your Business
Profitability ratios enable small organisations to assess how well they convert costs and investments into profit. It’s especially important to monitor your gross and net profit margins because they’re critical to your company’s long-term viability. Measure them to determine your profitability ratios. Set benchmarks (ratios you want to maintain) and goals (ratios you want to attain) using this information.
As you consider expanding your business, ROA and ROIC may become important. Even if you don’t formally measure them, keeping the ideas in mind is a good idea. Investing should pay for itself and then some. Determine which types of profitability ratios are most relevant to your firm with the help of your accountants or bookkeepers. They can also perform calculations for you and quickly share reports with accounting software such as Xero.
What Is the Importance of Profitability Ratios?
They are significant because they can show a company’s ability to create consistent profits (after deducting costs) and how well it manages investments to maximise shareholder returns. They can represent management’s capacity to achieve these two objectives, as well as the overall financial health of the organisation.
Is a Profit Ratio of 20 Acceptable?
A decent operating profit margin is often between 10 and 20%, which means the company makes 20 cents on every dollar of revenue after deducting operating expenditures. This can, however, differ from industry to industry.
How Can You Boost Your Profits?
There are four methods for increasing business profitability. Four important areas can help drive profitability. These include cost reduction, increased turnover, increased productivity, and increased efficiency.
What Are the Cons of the Profitability Ratio?
The profitability indicator has some cons. It is not always possible to determine the worth of a company or the performance of an investment. It should be used in conjunction with other measures, such as ROE and liquidity ratio, to be effective.
The Profitability Ratio Affects Which Stakeholders?
A company’s financial success can affect not only its owners and shareholders but also a wide range of other stakeholders. Managers, vendors, and employees are examples of stakeholders.
Conclusion
Profitability ratios assist any business in determining the difference between income and expenses. It is an accurate indicator of financial performance. When used properly, this makes it easier to identify areas where a company can save money. It can also assist in identifying revenue-generating opportunities. This is especially beneficial for small businesses. This is because they do not have as much capital as larger companies.
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