Profitability Ratio - Definition, Example & Formula
What is the Profitability Ratio?
Ratios of a company's profitability are a type of financial metric that helps measure and evaluate a business's capacity to generate profits. In addition, it is possible to evaluate these capabilities by looking at the income statement, balance sheet, shareholder's equity, or sales processes for a particular time period. In addition, the profitability ratio reveals how effectively the company uses its resources to generate profits and add value for its shareholders.
The profitability ratio is a useful tool for analyzing and comparing different companies or time periods that are analogous to one another. Therefore, it is in the best interest of any company to strive for a higher ratio, which would indicate that the company is doing well in terms of either its revenues, profits, or cash flow. In addition, the majority of creditors and investors make use of profitability ratios in order to evaluate a company's return on investment in relation to the level of resources and assets it possesses. In addition, the management of the company looks at these ratios to determine what kinds of adjustments need to be made to the way the business is run in order to achieve the desired level of profitability.
Types of Profitability Ratio
1) Gross Profit Margin
Analysts calculate a company's gross profit margin as the amount of money that is left over from product sales after the cost of goods sold has been subtracted from those product sales. This metric is used to evaluate a company's overall financial health (COGS). The gross profit margin is frequently presented in the form of a percentage of sales, and this metric is also known as the gross margin ratio on occasion.
2) Operating Margin
The operating margin can be calculated by taking the operating income and dividing it by the revenue. The operating margin of a company is a measure of its profitability that looks at revenue after taking into account both operating and non-operating expenses. When all of the operating expenses have been paid off, the amount of sales revenue that is left over is what is referred to as the return on sales, which is another name for the operating income.
3) Pretax Margin
The pretax profit margin is a tool used in financial accounting that measures the operational efficiency of an organization. It is a ratio that tells us the percentage of sales that has turned into profits or, to put it another way, how many cents of profit the company has generated for each dollar of sale before taxes are deducted, and it does this by telling us the percentage of sales that has turned into profits. When comparing the profitability of different companies operating in the same sector, the pretax profit margin is the metric most commonly used.
4) Net Profit Margin
One of the various profitability ratios that are utilized to determine the extent to which a company or an activity in the business world generates revenue is the profit margin. It indicates what proportion of total revenue has been converted into net income. To put it another way, the percentage figure indicates, in simple terms, how many cents of profit the company has generated for each dollar of sales.
5) Return On Assets (ROA)
The Return on Assets (ROA) ratio is used to determine how effectively a company can manage the assets it possesses in order to generate profits over an extended period of time. This accounting ratio is helpful to both management and investors because the primary purpose of a company's assets is to generate revenue and profits. It is helpful in determining the extent to which the company is able to turn its asset investments into earnings. If a company has a higher return on investment (ROI), this indicates that the company is more efficient and productive in managing its balance sheet in order to generate profits. When compared to a higher ROA, a lower ROA indicates that there is room for growth. It is always a good idea to compare the ROA of different companies in the same industry because these businesses have the same asset base.
6) Return On Equity (ROE)
The Return on Equity (ROE) Ratio is a type of accounting ratio that compares the net profit of a company to the total amount of shareholder equity in that company. There are two primary avenues through which shareholders can obtain equity. The first and primary source of funding for the business is the capital that was initially put into the enterprise. The second source is the company's retained earnings, which are profits that have been kept by the business rather than being distributed to shareholders. It shows, in basic terms, how much profit a company makes for each rupee that its shareholders have invested in the company. It is most frequently presented as a percentage. The return on equity does not take into account preferred shareholders, which are a special category of investors. The preference shareholders are assured of receiving a predetermined dividend payment each and every year. As a consequence, this metric reflects the profitability of the company as determined by the earnings of the ordinary shareholders.
7) Return on Capital (ROC)
Return on capital, also known as ROC, is a ratio that determines how efficiently a company converts its resources (such as debt and equity) into profits. To put it another way, return on capital (ROC) is an indicator of whether or not a company is making effective use of its investments to sustain and protect its long-term profits and market share against competition.
8) Return on Invested Capital (ROIC)
Return on Invested Capital, also known as ROIC, is a metric that calculates the percentage of a company's net profit that can be attributed to the equity and debt capital that was brought into the business. The rate of return on invested capital is frequently used as a metric for determining how efficiently capital is allocated. This is due to the fact that the consistent creation of a positive value is regarded favourably as an essential characteristic of a quality business.
9) Return on Common Equity (ROCE)
The return on common equity, also known as the ROCE ratio, is the amount of money that investors in common equity get back from the money they put in. The Return on Common Equity (ROCE) is distinct from the Return on Equity (ROE) in that the latter measures the total returns that the company generated on all of its equity while the former focuses solely on the returns that the company sees on its common equity. This calculation does not take into account the money received from investors in the form of preferred equity; as a result, the ratio is a better reflection of the returns common equity investors receive.
10) Return on Total Capital
Return on total capital is a profitability ratio that assesses investment returns from the total capital of the company, which includes both shareholders' equity and debt. The return on total capital, along with other capital ratios, indicates how well a company turns its capital into profits. This is the case for both small and large businesses.
The total return on capital of a firm is one metric that may be used to gain some insight into the strength of the company's capacity to sustain a competitive edge over other companies. In addition to this, it helps indicate how successfully the company is able to defend its long-term earnings and market share from the company's competitors.
11) EBITDA Margin
The EBITDA margin is a measurement of an organization's operating profit stated as a percentage of the organization's revenue. EBITDA stands for earnings before interest, taxes, depreciation, and amortization. EBITDA is an abbreviation that stands for earnings before interest, taxes, depreciation, and amortization. These are the earnings that are meant to be referred to by this phrase. If you are familiar with the EBITDA margin, you will have the ability to evaluate the actual performance of one company in relation to that of other companies operating in the same industry.
12) Operating Cash Flow Margin
The operating cash flow margin of a company is another name for the cash flow margin of that company. Sometimes both names are used interchangeably. This particular figure is one of the ratios that companies use to determine whether or not they are able to produce a profit, and it is one of the ratios that is used. In the context of this scenario, a corporation is disclosing the amount of profitability that can be attributed to the activities that are carried out by its operations. The activities that a company engages in to create and sell the products or services it provides are collectively referred to as its "operating operations."
Limitation Of Profitability Ratio
The profitability ratios, such as the net profit margin, are not "evergreen" measures that may be used to evaluate the profitability of different sectors of the economy. When compared with a bakery, for instance, a business that specializes in technology has a higher net profit margin.
The value of investment and profit can be easily adjusted to either enhance or decrease the profitability ratios according to their demands, which can be misleading for the investors and stakeholders in the company.
The ratios are determined by a number of different calculations that are performed behind the scenes of every value that is published on the financial statements. If there is a significant mistake or fraud in one of the line items, the consequence will be an incorrectly computed ratio, which could be risky for investors and businesses in the future.
Because of the possibility that they will be high or good due to the element of chance, ratios should not be adhered to in a dogmatic manner. It is always important to double examine the context behind ratios to ensure they are consistent with the research.