What Are Profitability Ratios?
Profitability ratios determine the ability of the company to generate profits as against : (i) Sales, (ii) Operating Costs, (iii) Assets and (iv) Shareholder’s Equity. This means such ratios reveal how well a company makes use of its assets to generate profitability and create value for shareholders.
Therefore, companies usually seek higher profitability ratios as these imply greater revenues, profits and cash flows for the company. With the help of these ratios, business owners or managers decide whether to distribute the earnings or reinvest the profits in business.
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Profitability Ratios Example
In order to explain the financial performance of ABC Ltd., “A to Z In Banking” prepared a case study. ABC Ltd is one of the largest fast moving consumer goods company in India. The case study analyzes the financial condition of the company using ratio analysis, one of the techniques of financial statement analysis.
Ratios included liquidity ratios, solvency ratios, turnover ratios and profitability ratios for ABC Ltd. The study was undertaken from the year 2007 to 2011. Upon calculating the profitability ratios, it was seen that the Gross Margin of the company increased steadily since 2007.
Such high gross margin for ABC Ltd. over the years revealed the company’s ability to sustain a low cost of production. Likewise, the Net Profit Margin calculated over the same period too increased significantly. High Net Profit Margin indicated increased return to the shareholders in the form of dividend and higher stock prices.
Thus, the above case study suggests that profitability ratios help in determining the return on sales and capital employed by the company. So, let’s understand the types of profitability ratios and their significance.
Types of Profitability Ratios
There are various types of profitability ratios used by the financial managers to analyze the financial performance of the companies. These are divided into two categories: Margin Ratios and Return Ratios.
Margin Ratios determine the profitability of the company at different levels of cost. This includes Gross Margin, Operating Margin, Pre-Tax Margin and Net Profit Margin. As different cost levels are taken into account, the margins decrease. The various cost levels include cost of goods sold, operating and non-operating expenses and taxes.
Gross Profit Margin
Gross Profit Margin measures the Gross Profit against the sales revenue of a business. This margin reveals the amount of earnings that a company is generating after considering the costs incurred to produce goods and services.
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Higher Gross Profit Margin ratio indicates that the company is quite efficient in carrying out its business operations leading to higher gross profit. Such increased gross profits are sufficient to cover the operating expenses, fixed expenses, dividends and depreciation. Furthermore, high gross profit also leads to increased net earnings for the business.
Likewise, low GP margin suggests higher cost of goods sold for the company. Where higher Cost of Goods Sold (COGS) can be an outcome of lower sales volume, lower selling prices, lower COGS, cut-throat market competition etc.
The formula for Gross Profit Margin is as follows:
Gross Profit Margin = Gross Profit/Revenue
Operating Profit Margin
To arrive at Operating Profit Margin, you first need to calculate Operating profit. Operating Profit is determined by subtracting operating costs such as selling, general and administrative expenses from the gross profit. Then Operating Profit Margin is calculated by dividing operating Profit with Net Sales.
If operating profit margin increases faster as against the Gross Profit Margin, it suggests that the company’s management is efficient. Thus, it reveals that the company is efficient in controlling the operating costs. So, in a way it indicates the quality of the management’s decision making.
On the other hand, a lower operating profit margin reveals the inability of the management to regulate its operating costs.
Following is the formula for Operating Profit Margin:
Operating Profit Margin = Operating Profit/Revenue
In order to calculate Pre-Tax Profit Margin, you first need to determine Pre-Tax Income or Earning Before Tax (EBT). EBT is nothing but operating profit less interest. Thus, Pre-Tax Profit Margin is the ratio of Pre-Tax Income to Revenue.
This ratio indicates the effect of non-operating items (both income and expenses) and interest (leverage) on the profitability of business. A high Pre-Tax Profit Margin ratio could increase as an outcome of increasing non-operating income of the business. This could be a hint towards an intentional change in the focus area of the business that might continue in the future.
Following is the formula for Pre-Tax Margin Ratio:
Pre-Tax margin = Earnings Before Tax But After Interest (EBT)/Revenue
Net Profit Margin
Net Profit Margin refers to the percentage of profit a company generates from its revenues. In other words, this ratio indicates the amount of net profit a company is able to generate for every unit of increase in revenue. Thus, this ratio relates revenue from operations of a business to its net profit. The net profit is calculated after considering all the operating and non-operating incomes and expenses of the business.
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Following is the formula for Net Profit Margin:
Net Profit Margin = Net Income/Revenue
Return ratios indicate the ability of a company to produce returns for its shareholders. The commonly used return ratios include return on:
- Total Capital
Return on assets as the name suggests indicates return generated by a company on its assets. A higher return on assets ratio indicates that the company is able to generate more income from the given amount of assets.
For calculation of this ratio, interest expense is added back to the Net Income. Further, this interest expense is adjusted for income taxes. Such an adjustment is made to the net income since it is determined after deducting both interest expenses and taxes. There is an issue with taking net income directly without adjusting for interest and tax.
Net Income is nothing but a return to equity shareholders. But the average total assets in the denominator are funded both by equity and debt. Hence, financial managers prefer to add back interest expense to net income after adjusting for taxes. Thus
Return On Assets = (Net Income + Interest (1-Tax Rate))/Average Total Assets