Profitability Ratios

Profitability Ratios

The profitability ratios are a financial measurement measuring the relationships between costs and revenues. The ratio tells the costs needed to achieve the desired revenues. It can be applied at different levels of organization depending on the needs to be catered to. This article will discuss different types of profitability ratios.

The profitability ratio doesn’t define the entire business situation. It is only one aspect of business standing. For analyzing any business’s current situation and future, many factors are considered for financial analysis. Other financial information is studied along with profitability ratios to understand future success. This article focuses entirely on profitability ratios, their types, uses, and benefits.

What is meant by profitability ratio?

In general, profitability ratios are measurement that measures any business organization’s efficiency, profitability, and effectiveness. These profitability ratios analyze and calculate the revenue which is available after deducting all the business expenses.

The profitability ratio helps a businessman understand whether a company can convert all sales revenue into net income. The profitability ratio helps a company know how they are using its assets. It shows how well a company can generate profit.

If the profitability ratio is high, it means that the company is successful in earning more profit from fewer or limited assets. The less profitability ratio is not desirable because it shows the missed opportunities and projects that could have helped generate more profit. The low profitability rate is not a sign of danger, but it shows that the organization is in the developing phase and they need to change its strategies somehow. 

What are the uses of the profitability ratio?

The profitability ratio has many uses, but the most widely known and accepted are as follows:

  • It helps in comparing different companies
  • It helps in decision making
  • It helps in deciding whether one should invest in any company or not
  • The business owners get an estimate of the investment 
  • It helps in determining the use of cash flows
  • It also helps in determining the cash returns

What are the main types of profitability ratios?

Profitability ratios can be divided into three major types:

  • Contribution profitability ratio
  • Asset use profitability ratio
  • Operating profitability ratio

Contribution Profitability Ratio

The first type – The contribution Profitability Ratio, is really helpful for companies in measuring the effectiveness of their marketing efforts. The contribution margin is labeled as the gross profit and also the revenue generated from the sold goods. It is formulated as follows:

Contribution Margin = Total revenue – Cost of sold goods 

Asset Use Profitability Ratio

The second type – The asset use profitability ratio entire focuses on assets. It works with fixed and total assets and is used to generate sales revenue. The assets use profitability ratio is usually calculated after deducting the operating costs from the revenue. It is further divided into two subtypes which are:

  • Fixed Asset Turnover Ratio: It measures the fixed assets used by the company and is calculated by dividing the total revenue by the fixed assets.
  • Inventory Turnover Rate: it deals with the company’s inventory. It is calculated by dividing the total net sales revenue by the average inventory of a company.

Operating Profitability Ratio

The last one – The operating profitability ratio determines the company’s sales revenue. It can be calculated by deducting the cost of sold goods. The formula used for calculating the Operating Profitability Ratio is:

Operating Profitability Ratio = Net Income / (by) Sales

Which is the best profitability ratio?

The profitability ratio is really essential for any company because it measures the ability of a company to convert sales revenue into net income. Out of all three profitability as mentioned earlier ratios, the last one – the operating profitability ratio- is considered the best. It is best because it tells an organization about the management of costs. We get the operating profitability ratio after deducting all the operating expenses from the sales. 

The contribution profitability ratio is also best for marketing purposes. A lot of companies use this to measure the effectiveness of their business. It includes all the marketing campaigns, efforts, and marketing budget.

Which Profitability ratio should you use for your business?

There is no thumb rule to pick any one profitability ratio for your company. One ratio is not enough for any business. It is essential and effective to use different profitability ratios for the success of your business. All three profitability ratios can help you identify the problems within your company. Each profitability ratio caters to the different aspects of your business. Together, they can highlight the problems which can help you rethink your business and develop new strategies.

What is the difference between the Margin ratio and the return ratio?

Margin ratios deal with turning sales into profits. At the same time, the return ratio is about the actual ability of a company to generate owner wealth and shareholders. 

PROFIT MARGIN RATIO

There are three margin ratios that you need to track for your business. 

  • RATIO #1: GROSS PROFIT MARGIN

It is the most common ratio type, which calculates the leftover amount after seeing the covering cost of sold goods. The digits used to calculate this ratio are mentioned on the income statement of a business. The higher the profit margin, the better the efficiency of earning revenue.  The formula for calculating gross profit margin is

The gross profit margin = (total sales – the cost of goods sold) ÷ total sales.

  • RATIO #2: OPERATING PROFIT MARGIN

It is a margin before the deduction of taxes of interest. It can easily be calculated by deducting operating costs from gross profit. Such expenses include salaries, utilities, administration tasks, general tasks, rent, etc. it is best to check your seasonal sale and how much you can save generally. The formula to calculate the operating profit margin is as follows:

The operating profit margin = operating profit ÷ the revenue

  • RATIO #3: NET PROFIT MARGIN

After paying all the operating and nonoperating expenses, how much your profit your business shows is the net profit margin. A high-profit margin shows that your company is successfully generating income and your managing costs excelling. Here is the way to calculate the net profit margin:

The net profit margin = net income ÷ revenue

RETURN RATIO

The below given two ratios are essential to see:

RATIO #4: RETURN ON ASSETS

This ratio majorly focuses on using assets for the generation of profitability. It provides beneficial information which informs any business on how to use resources and assets for the generation of profit. To calculate return on assets, use the below-given formula:

return on assets = net income ÷ total assets

RATIO #5: RETURN ON EQUITY

It provides really important information for investors and shareholders of any business. It helps in measuring the return on any investment put in by investors. It helps in getting new investors too. The return on equity can be gained by:

return on equity = net income ÷ average shareholder’s equity

CONCLUSION

Managing business finances and expenses is not an easy task. It becomes challenging for a business owner to manage business finances along with maintaining profitability. All the ratios mentioned above need to be measured to run a successful business. All ratios need to be measured in time to effectively run the business without an iota of risk in it. 

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