What are profitability ratios? (With examples and formulas)
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 a type of financial metric that organisations use to assess and analyse their financial performance. Using these ratios can help companies calculate and determine their financial health and success, which indicates the number of returns shareholders receive. Performing financial checks using ratios throughout the fiscal year can accurately pinpoint when and where a company is thriving financially and also identify how it can increase its profits moving forward. In this article, we explain what profitability ratios are and outline the different types of ratios by providing examples.
What's a probability ratio?
A probability ratio is a specific financial metric that a company can use to measure and analyse its financial health. This might mean looking at the company profits relative to its operating costs, shareholder equity, revenue and balance sheet assets over a specified time frame.
Probability ratios provide a clear breakdown of a company's assets and look at the generation of profit and value. If probability ratios are high, then a company is performing well financially due to high revenues, profits and positive cash flow. Using ratios is a useful way to compare a company with its competitors or with previous fiscal years.
The types of profitability ratios
There are many different types of ratios that a company can use to inspect, analyse and assess their financial health and performance. Generally, profitability ratios fall into two distinct categories which are:
Margin ratios focus on a company's ability to transform sales into profits across different measurements and cost levels. Examples of margin ratios include:
operating profit margin
gross profit margin
net profit margin
cash flow margin
earnings before interest and taxes (EBIT)
operating expense ratio
Margin ratios can be useful for companies that are trying to assess their valuation, company performance and credit analysis.
Return ratios focus on the financial returns that a company can provide its shareholders. There are many return ratios that organisations use to assess this, including:
return on assets
return on debt
return on retained earnings
return on revenue
return on equity
cash return on assets
return on debt
return on capital employed
Commonly used profitability ratios
Businesses can use a variety of ratios to inspect their financial health over a set period. This might compare income to assets, equity or sales for a company. Below are some of the most commonly used ratios with a description of their purpose:
Operating profit margin
Operating profit margin is a metric that lets companies inspect their earnings before factoring in taxes and any interest expenses from investments. An organisation that manages to achieve high operating profit margins have a good financial standing and can pay off their various debts, shareholders and financial obligations without impacting their business. A company is better prepared to handle fluctuations in the market and economy and can offer lower prices than its competitors with lower profit margins.
Gross profit margin
Gross profit margin is a profitability ratio that measures gross profit in comparison to sales revenue. Businesses can calculate the gross profit by deducting the sales from the cost of all goods sold and then dividing by the gross profit. The total profit is then deducted from the cost of utilities including rent and staff salaries.
Earnings before interest, taxes, depreciation and amortisation (EBITDA) encompasses the profitability of a business before factoring in non-operating costs. The non-operating costs include interest, taxes, depreciation and amortisation. EBITDA is most commonly used instead of net income earnings, as a metric, because it provides a more exact measurement of organisational performance. This is because it can show profits for a company before accounting deductions.
Net profit margin
Net profit margin gives companies a complete picture of their profitability. Organisations can calculate their net profit margin by dividing their net income from their total revenue. This approach considers interest, taxes and other extra company expenses. It can't compare against competitors as it includes one-time expenses and other gains that aren't trended for every financial year.
Cash flow margin
Cash flow margin looks at the relationship between the total sales of a business and its operating cash flow. This is a good metric for measuring conversions from sales into cash for a company and can provide a clear picture of operational health.
High percentage cash flows can provide companies with more available funds to pay bills, utilities, suppliers and service debt. Negative cash flow margins highlight lost money for a company even in the face of profits and sales. If a company is struggling with poor cash flow, it may look to raise funds through investment or loans to keep afloat.
Return on equity
Return on equity (ROE) looks at the rate of return for stockholders' equity concerning the percentage of net income that a business has. Investors and stockbrokers tend to use this metric to assess the health and standing of a business and to determine if a company generates profits consistently or if there are highs and lows of profitability.
If a business has a strong ROE ratio, investors are more likely to divide funds towards company stocks. Companies with high ROE ratios generally don't depend on debt financing and they're more stable and able to generate cash through their operations.
Return on assets
Return on assets (ROA) looks at the percentage of net earnings for a company concerning its total assets. ROA assesses how much profit a company makes after deductions, such as taxes. It measures how asset-intense a business is to gauge its financial standing. For example, companies with high asset intensity tend to require larger investments for operations, such as purchasing expensive machinery or equipment to earn profits. Many manufacturing companies, such as those in the automotive industry, have high asset intensity. Less asset-intensive industries require less investment and profit to operate, such as software companies or marketing agencies.
Return on invested capital
Return on invested capital (ROIC) looks at the measurements of individual providers of capital for a business, such as shareholders. ROIC is essentially the same as ROE, but with the addition of greater scope for things like returns generated from capital offered by shareholders.
Examples of profitability ratios
Ratios can provide vital information for businesses and their stakeholders to calculate margins and returns and to determine the financial health of a company. To give you a good idea of how these ratios work in practice, here are a few real-world examples:
Scott's Tots is a toy company that earns £200 million in revenue with production costs of £80 million and £25 million in operating costs. Amortisation and depreciation for the company amount to £15 million, providing a total operating profit of £80 million. Interest expenditure for Scott's Tots is £5 million, which leaves earnings before tax of £75 million. Net income is £60 million after deducting £15 million in taxes with a tax rate of 20%. When bringing depreciation, amortisation, interest and taxes back into the net income of Scott's Tots, the EBITDA comes to £95 million.
With that information, we can break down the companies financials as follows: Net income: £60,000,000 Depreciation and amortisation: £15,000,000 Interest expenses: £5,000,000 Taxes: £15,000,000 EBITDA = £95,000,000.
Gross profit margin example
Wildfire Technology generates £30 million in revenue by creating applications, with £12 million going towards goods and service expenses. Wildfire Technology's profit is £30 million minus the £12 million spent on goods and services expenditure. They can calculate their gross margin by looking at the gross profit of £18 million and dividing it by £30 million, which is 60%. For every £1 earned in gross margin profit, Wildfire Technology earns 60p. The formula for calculating the gross profit margin looks like this:
Gross profit margin = Net sales - Cost of goods / Net sales or 0.40 = £30 million - £12 million / £18 million.
Return on equity example
During the Q3 financial period, Moolah Bank calculated a net income of £14 million with shareholder equity reported to be £58.17 million. Calculating the ratio for this is achievable using the following formula: ROE = Net income / Shareholder equity or 24.06% = £14 million / £58.17 million. If the standard ROE was set at 20% for the banking industry, then Moolah Bank has gone beyond the average ROE for the industry. So, shareholders can look at this and know they're generating 24p of profit for every £1 made by the bank.
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