What Is the Profitability Ratio?

Curious about a company’s financial management? Start with profitability ratios! These financial metrics show how effective a business model is. In this article, we will guide you through the different types of profitability ratios and their significance.

What Are Profitability Ratios?

Profitability ratios aim to measure the overall performance of the firm’s profitability relative to revenues, assets, equity, and capital. It helps determine the firm’s performance on various profitability levels like gross, operating, net, etc. 

If a company shows a high profitability ratio, then it is indicative of sustained future growth. This is because a company bringing in higher profits with a given set of resources can grow faster when and as they reinvest their profits and raise capital.

Types of Profitability Ratios

The following are the different types of profitability ratios that can be used to measure a company’s financial performance:

1. Gross margin
2. Operating margin
3. Net profit margin
4. Return on Assets (ROA)
5. Return on Equity (ROE)

What Are the Most Important Profitability Ratios?

The following are some of the most important profitability ratios to look at while investing in a company:

1. Gross Profit Margin 

It is the ratio of gross profit, i.e., revenue from operations minus the cost of goods sold, to total revenue. This measures the efficiency of a company in managing its basic production costs. This ratio is critical as the level of gross profit depends largely on the company’s chosen business model and not on external factors that are beyond the company’s control, like changing interest rates, tax rates, rate of depreciation, etc. 

In some cases, it can also be indicative of the capability of the company to charge a higher price to its customers based on market share, as well as negotiate better deals with its suppliers to reduce costs. 

Gross Profit Margin = Gross Profit/Revenue

2. Operating Profit Margin

Gross profit margin has a problem, i.e., it ignores operating expenses like selling and general and administrative expenses. Hence, we use operating profit margin. This is the operating profit, i.e. gross profit less operating expenses, compared to total revenue. 

At this point, we are checking not only the company’s business model but also its ability to handle it all based on controlled internal operational costs. A higher ratio indicates a greater ability of the firm to generate profits from its core business activity. A lower ratio may suggest challenges in controlling operational costs. 

3. Net Profit Margin 

This ratio shows how much net income has been made by the firm out of a given revenue. Net income is the earnings that remain once the production and operational costs, interest and taxes are paid. A lower ratio means that the take-home profit as a proportion of revenue is less. The net profit shows how much money the company truly makes after all its costs and taxes are taken care of.

Net Profit Margin = Net Income/Revenue

4. Return on Assets

This ratio measures a company’s ability to generate returns from its assets. It is also a measure of capital efficiency because it measures how well the company can utilise its assets to generate profits. Typically, ROA is calculated using net income. A lower ROA ratio might indicate that the company may be less effective in utilising its assets to generate earnings. That being said, ROA can be different for different industries.  

Return on Assets = Net Income/Average Total Assets

5. Return on Equity (ROE)

It measures how much returns a company provides to its shareholders. It shows how well the capital raised via equity has been utilised to generate profits. This is the ratio of net income to average total equity. A higher ratio indicates that the company efficiently uses its shareholder’s equity to generate profits for its shareholders. 

Return on Equity = Net Income/Average Total Equity

Read More About Return on Equity

Why Are Profitability Ratios Significant?

Profitability Ratios are significant because they tell us the following things about a company:

1. Overall business model: Profitability ratios measure a company’s ability to generate profits from its sales, assets, and equity. They can help you assess how efficiently a company converts its revenue into profit. It also shows whether the business model of the company can sustain itself or will need significant external assistance to sustain itself.
2. Efficiency: Some ratios, like gross profit margin and operating profit margin, reveal how well a company controls its production and operating costs. A low ratio in these areas might indicate inefficiencies.
3. Return on investment: Ratios like ROA and ROE show how effectively a company is using its assets and equity to generate profits for its stakeholders.
4. Benchmarking: Comparing a company’s profitability ratios to its historical performance and industry peers can provide valuable insights into its relative financial health and competitive position.

Limitations of Profitability Ratios

1. Industry Dependence: Ratios vary significantly across industries. Comparing a tech company’s ratio to a retail store’s wouldn’t be meaningful.
2. Short-Term Focus: Ratios might not capture long-term profitability trends or the impact of non-recurring events.
3. Accounting Manipulation: Companies can use accounting practices to inflate or deflate ratios, making them less reliable.
4. Limited Scope: Ratios provide a single snapshot and don’t offer insights into underlying business drivers or risk factors.
5. Sustainability Concerns: High profitability achieved through unsustainable practices might not be indicative of long-term health.
6. Future Uncertainty: Ratios are based on past data and cannot predict future performance with certainty.
7. Qualitative Factors Omitted: Important aspects like brand strength, management quality, and competitive landscape are not reflected in ratios.

How Is Business Profitability Best Measured?

Business profitability is best measured using multiple profitability ratios and viewing them in the larger context of market trends. Net profit margin paints a clear picture of overall efficiency, showing how much profit trickles down from each dollar of revenue. But gross profit margin focuses on core operations, revealing how well costs are managed in producing goods or services. For deeper insights, return on assets indicates how effectively assets generate profit, while return on equity highlights shareholder return.

However, a larger context is necessary. For example, suppose an industry is going through a sudden drop in demand or an increase in raw material cost, whereby most companies face a drop in profitability. In that case, you need to check whether the cause behind a fallen demand or increased cost is a sustained one or a temporary one. You need to identify what the actual cause behind the drop in profit is and whether that can change in the coming months and years.

Final Words

Now that you know about profitability and how to measure it, check out which firms are currently profitable and how their stock prices are doing. If you are new to the stock market, open a free demat account with Angel One today!

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