Profitability Ratios and Why They Matter

Posted in Accounting, Financial Management, Management Accounting, Principles of Management on Mar 29th, 2014 | 0 comments

Profitability ratios are metrics that assess a company’s ability to generate income relative to its revenue, operating costs, balance sheet assets, or shareholders’ equity. 

Profitability ratios show how efficiently a company generates profit and value for shareholders.

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In general two groups of profitability ratios are calculated.

1. Profitability in relation to sales.
2. Profitability in relation to investments.

Profitability Ratios can be Classified into five types

1. Gross profit margin or ratio
2. Net profit margin or ratio
3. Operating profit margin or ratio
4. Return on Assets
5. Return on Equity

 1. GROSS PROFIT MARGIN OR RATIO

It measures the relationship between gross profit and sales. 

It is calculated by dividing gross profit by sales.

• Gross profit margin or ratio = Gross profit X 100 / Net sales
• Gross profit is the difference between sales and cost of goods sold.

2. NET PROFIT MARGIN OR RATIO

It measures the relationship between net profit and sales of a firm. 

It indicates management’s efficiency in manufacturing, administrating, and selling the products.  It is calculated by dividing net profit after tax by sales.

 Net profit margin or ratio = Earning after tax  X  100 / Net Sales

3. OPERATING PROFIT MARGIN OR RATIO

It establishes the relationship between total operating expenses and net sales. 

It is calculated by dividing operating expenses by the net sales.

• Operating profit margin or ratio = Operating costs  X  100 / Net sales

(0r)

• Cost of goods sold + Operating expenses * 100 / Net sales

Operating expenses includes cost of goods produced/sold, general and administrative expenses, selling and distributive expenses.

4. RETURN ON ASSETS

Return on assets is the ratio that is used to measure the company’s ability to generate profit by using its whole resource, the assets.

It shows the percentage of the net income or net profit comparing to the average total assets.

Return on assets shows how efficient the company is in using the assets to generate profits in a period of time.

The high return on assets usually shows that the company performs well in making a profit from the assets it has.

Return on assets can be calculated by comparing net income or net profit after interest and tax in the period to average total assets.

Return on Assets = Net Profit / Average Total Assets

5. RETURN ON EQUITY

Return on equity is the ratio that is used to measure the company’s ability to generate profit by using its investors’ money.

It shows the percentage of the net income or net profit comparing to the average total equity.

Return on equity shows how efficient the company is in using the investor’s money to generate profits in a period of time.

The high return on equity usually shows that the company performs well in making profits from its investors’ money.

Return on equity can be calculated by comparing net income or net profit after interest and tax in the period to average total equity.

Return on Equity = Net Profit / Average Total Equity