What Are Profitability Ratios? (With Types And Examples)
By Indeed Editorial Team
Published 25 April 2022
The Indeed Editorial Team comprises a diverse and talented team of writers, researchers and subject matter experts equipped with Indeed's data and insights to deliver useful tips to help guide your career journey.
Profitability ratios are financial metrics that help an investor and analyst measure a company's performance. Using various types of profitability ratios, analysts can assess a business' financial performance and calculate the returns a company can offer to its shareholders. Learning more about profitability ratios and how to use them can help you identify ways to increase profitability. In this article, we answer “What are profitability ratios?” discover when to use them and explore various types of ratios with formulas and detailed examples.
What are profitability ratios?
The answer to the question, “What are profitability ratios?” is that they are metrics that evaluate and measure a business' ability to generate profit relative to the operating expenses, revenue, shareholder's equity and assets during a specific time period. These ratios indicate how efficiently a business generates value and profit for shareholders. Usually, companies prefer a higher profitability ratio because it shows that a business generates revenue, profits and cash flows. These ratios are helpful when analysts or investors compare them with a competitor or previous fiscal year.
Types of profitability ratios
The different types of profitability ratios are:
A margin ratio calculates the company's ability to convert sales into profit. You can use these ratios in credit analysis, valuation and financial performance analysis. Some commonly used margin ratios are:
Operating profit margin
This profitability ratio measures the percentage of profit a company produces from its operations before deducting the interests and taxes. A company with a higher operating profit margin can easily pay off debts and other financial obligations. The formula for calculating this ratio is:
Operating profit margin = operating profit / total revenue
Gross profit margin
A gross profit margin calculates the amount left with a company after subtracting the cost of goods sold (COGS). It measures the gross profit to sales revenue. A fluctuating gross profit margin indicates poor management and inferior products. The formula for calculating this ratio is:
Gross profit margin = (net sales – COGS) / net sales
Earnings before interest, taxes, depreciation and amortisation or EBITDA margin gives an exact measure of a company's financial performance. This margin ratio represents a company's profitability before considering the nonoperating items like taxes and interest, and noncash items, such as amortisation and depreciation. The formula for calculating this ratio is:
EBITDA = EBITDA / net revenue
EBITDA = net income + depreciation + amortisation + taxes + expenses
Net profit margin
Net profit margin measures how much profit or net income a company generates as a percentage of revenue. Using this ratio, an investor assesses whether its management generates enough profits from its sales. They also determine if the company can contain the overhead and operating costs. The formula for calculating this ratio is:
Net profit margin = net profit / revenue
Cash flow margin
The cash flow margin measures the efficiency with which a company converts its sales into cash. A high cash flow margin shows that a company has more cash available to pay suppliers, dividends, service debt and utilities. A negative cash flow margin can make a company lose money even if the company is generating profits. The formula for calculating cash flow margin is:
Cash flow margin = (net income + amortisation + depreciation + change in working capital) / sales
A return ratio represents a company's ability to generate returns for its shareholders. Some commonly used return ratios are:
Return on assets
Return on assets, or ROA, shows how profitable a company is relative to its total assets. This ratio tells how much after-tax profit a business can generate for every one rupee of assets the company holds. The ROA measures the asset intensity of the company. Companies with a high ROA usually require a significant investment to purchase machinery or equipment for generating profits. Some asset-intensive companies are car manufacturers, and some less asset-intensive are marketing and software companies. The formula for calculating ROA is:
Return on assets or ROA = net income / total assets
Return on equity
Return on equity or ROE measures how efficiently a company can handle shareholders' contributions. It calculates the company's profitability in relation to the stockholder's equity. A higher ROE shows that a company is efficient at generating income from equity financing. Usually, analysts look for a favourable ROE before purchasing a company's stock. The formula for calculating ROE is:
Return on equity or ROE = net income / shareholder's equity
Return on invested capital
Return on invested capital, or ROIC, calculates a company's return on its invested capital. The ratio indicates how efficiently a company uses an investor's funds to generate income. Often, analysts use this ratio as a benchmark to calculate the value of other companies. The formula for calculating ROIC is:
Return on invested capital or ROIC = net operating profit before tax / invested capital
When to use profitability ratios?
Here's when you can calculate and track the profitability ratios:
Evaluating a company's performance
Analysing a company's profitability ratio quarterly or annually provides visibility for how a business is performing. This ratio is essential to assess a company's financial health and give evidence of future growth. When comparing these ratios over a specific time period, you can create future strategies and explain why the company underperformed in those years.
Identifying areas that require improvement
Calculating the profitability ratios helps you identify areas of the business that require improvement. For instance, a SaaS company acquires more clients than before. Upon analysing their profitability ratio, the company understands that the operating profit margin is low, while the gross profit margin is high. These ratios reveal that though the company is acquiring new clients and increasing sales, the operational expenses to manage the new client are extremely high. Using this analysis, a company can explore ways to reduce operational expenses.
Finding new investors
Profitability ratios predict the financial stability and the profit a company generates after covering all its expenses. Before investing in the company, investors want to know its profitability and its ability to manage expenses. They also look at the company's financial history to ensure there is evidence of growth.
Examples of profitability ratios
Using the profitability ratio, you can calculate the return a business might provide to a shareholder or bondholder. Here are a few examples that can help you understand the different profitability ratios:
A technology business called Sumant Electronic Ltd. makes products such as a washing machine, television and vacuum cleaner. Sumant Electronics Ltd. made ₹10,00,000 net income at the end of the fiscal year. Assets of the company totalled ₹60,00,000 for the same year. In the previous year, the total assets were ₹40,00,000. The average of the total assets was ₹50,00,000. The ROA of the company is:
ROA = net income / total assets
ROA = ₹10,00,000 / ₹50,00,000 = 0.2 or 20%
This means that the company has a return on an asset of 20%. Sumant electronics made about 20 paise in profits for every rupee they spend on the company's assets.
Gross profit margin
A clothing company called Gym and Trends reported a total sales revenue of ₹2,00,00,000 and the COGS of ₹1,00,00,000 in their financial statement. You can calculate the gross profit margin using:
Gross profit margin = (net Sales – COGS) / net Sales
Gross profit margin = (₹2,00,00,000 – ₹1,00,00,000) / ₹2,00,00,000 = 0.5
The company's gross profit margin is 50%. After paying direct costs associated with producing clothes, the company still has half of its revenue left. For every rupee a company earns in sales, the company earns 50 paise in gross profit before paying any expenses.
Summer Shoes Private Ltd generates ₹6,00,00,000 in revenue and the COGS is ₹2,00,00,000. Depreciation and amortisation cost equals ₹15,00,000. Interest expenses are ₹5,00,000, and the tax expenses are ₹10,00,000. The gross profit or net income of the company is ₹4,00,00,000. You can calculate the EBITDA using:
EBITDA margin = EBITDA / net revenue
EBITDA = net income + depreciation + amortisation + interest expense + taxes
EBITDA = ₹4,00,00,000 + ₹15,00,000 + ₹5,00,000 + ₹10,00,000 = ₹4,30,00,000.
EBITDA margin = ₹4,30,00,000 / ₹6,00,00,000 = 0.716
A high EBITDA margin means that your operating costs are a low percentage of the overall revenue. You can use the revenue to reinvest into your company or payout to the shareholders.
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