Profitability Ratios and Its Types

There are numerous financial  metrics that an investors needs to check before investing in a company. If you're not tracking profitability ratios of a company, you probably should be.

Read on for a breakdown of what profitability ratios are, their importance, various types of profitability ratios and how to calculate them. 

What are Profitability Ratios?

Profitability ratios are financial metrics that helps to evaluate the ability of a company to generate profit relative to its revenue, operating costs, assets, and shareholder equity during a specific period. They are used to evaluate the company’s ability to generate income as compared to its expense and other cost associated with generation of income during a particular period. They indicate company’s overall efficiency in using its assets to generate profit and value for shareholders.

 

Why are profitability ratios important?

The sole purpose of commencing a business is to earn profit. In other words, the sole purpose of a business is to earn more than they spend. To assess the growth of any business, careful study of profitability of the company is vital. Profitability ratios helps to indicate whether a company is heading in right direction or not. It provides potential and existing investors with information regarding financial state of the company.

Types of Profitability Ratios

1)Margin Ratios :

 It indicates company’s ability to convert sales into profit at different degrees of measurement. It includes gross profit margin, operating profit margin and net profit margin.

a)Gross Profit Margin: It measures how much sales revenue is left out after deducting cost of goods sold (COGS). COGS refers to the direct cost of producing the goods sold by the company. It includes direct material and labor cost involved in manufacturing product.

High gross profit ratio indicates high efficiency of core operations. On the other hand, low ratio indicates adverse purchasing policies, low selling price, and stiff competition.

b)Operating Profit Margin: The words operating profits and earnings before interest and taxes (EBIT) are used synonymously. Operating profit is arrived after deducting operating expense from gross profit. These expenses include sales and administration expense, admin and distribution expense, commission expense and other general costs. Operating profit margin measures how much sales revenue is left out after deducting operating costs and COGS.

High operation profit margin indicates that the company can do well even in economic slowdown. This ratio can also be used to evaluate management’s ability to improve profitability of the company by managing operating costs. If a company has high gross profit margin and low operating profit margin, it indicates that the company is spending too much on operating costs.

c)Net Profit Margin: Net profit is the bottom line of the profit and loss statement. Net profit is arrived at after deducting all business expenses from sales revenue. Net profit margin indicates how much sales revenue is left out after deduction all expenses. It shows the final picture of how profitable the company is after all expenses are considered.

High net profit margin indicates how well a company manages expenses and generate profit. A drawback is this ratio is that it includes a lot of noise such as one time gain and losses which makes it harder to compare it with competitors.

 

2) Return Ratios:

 It indicates company’s ability to generates profits for its owner and shareholder. Two major return ratios are return on asset and return on equity.

a)Return on Asset (ROA): It indicates the percentage of net profit relative to the company’s asset. It measures how successfully company uses its asset to improve its bottom line. It reveals how much net profits a company generates for every rupee of asset held. It helps to measure asset intensity of a business.

Low ratio indicates high asset intensity which means that company requires huge investment to generate income. High ratio indicates low asset intensity which means that company can generate income without huge capex.

b)Return on Equity (ROE): It indicates percentage of net income relative to its shareholders’ equity. It indicates how well a company uses its shareholders investments to generate profit.

ROE is used to evaluate management performance. A low ROE indicates inability of company’s management in generating returns on investors’ funds and high ROE indicates management’s ability to generate good return on investors’ funds.

Interpretation of Profitability Ratio

Profitability ratios on standalone basis are often misguiding. For eg. On standalone basis, IT companies will look attractive as they have high margin ratios. But almost every IT company have high margin ratios because of industry structure. So, it is necessary to compare profitability ratios against some parameter. Profitability ratios are useful when they are analyzed in comparison with competitor or industry average or compared with previous periods. Higher profitability ratios are more favorable.

Example of Profitability Ratio

For 2020,

Gross Profit Margin = 265/936 

                                    = 28.31%

Operating Profit Margin = 160/936

                                           = 17.09%

Net Profit Margin = 98/936

                                = 10.47%

Return on Assets and Return of Equity requires average total assets and average shareholders equity. For this we need current and previous year value. So we  need 2018 values to calculate these ratios.

For 2021,

Gross Profit Margin = 310/1468 

                                    = 21.11%

Operating Profit Margin = 167/1468 

                                           = 11.37%

Net Profit Margin = 103/1468 

                                = 7.01%

Return on Assets = 103/ (1550+1400)/2 

                              = 6.98%

Return on Equity = 103/ (1003+900)/2 

                               = 10.83%

Final Words:

A company with higher profitability ratio than its competitors or past performance is considered good. Remember, profitability ratios are not the only ratios that you should track. Look for liquidity ratios, turnover ratios, valuation ratios and solvency ratios as well and do your exhaustive research  before investing.

Happy Investing!