What are Profitability Ratios?
Profitability ratios are one of the most crucial groups of financial metrics. These are useful in assessing a company’s or business’s ability to generate profits relative to various other metrics. These may include its revenues, equity, assets, or operating costs, among other figures. Profitability ratios show how efficiently a company generates profits for the given resources they use.
A company’s profitability ratios usually consider its net income from its Income Statement. However, some of them may also consider its gross or operating income. Investors prefer investing in companies that have high profitability ratios. However, on their own, profitability ratios may not be meaningful. Therefore, investors will need to use them comparatively instead.
There is no formula for the profitability ratio itself. However, investors may use several other profitability ratios to assess a company’s efficiency in generating profits.
What are the various types of Profitability Ratios?
Investors can use various profitability ratios to evaluate a company. Among those, the most prevalent ones are below.
The Profit Margin
The profit margin is a profitability ratio that compares a company’s profits with its revenues. There are various types of profit margins, such as gross profit, operating profit, or net profit margin. Each of these shows the percentage of sales that a company can convert into sales. The margins may reduce as the company’s sales decrease or its expenses increase.
For companies, higher net profit margins indicate their efficiency in converting sales to profits. However, as with any other profitability ratio, it is best to consider a company’s performance comparatively. The formula for the profit margin is as below.
Profit Margin = Net Profit / Net Sales
Instead of the net profit, investors can also use gross profit or operating profit to determine the relative profit margin. However, each type of profit margin will return a different result.
Earnings Per Share
Earnings per share is another profitability ratio that investors commonly use. It measures a company’s profits in relation to the number of its outstanding shares. Sometimes, accounting standards may require companies to present their earnings per share on their Income Statement.
A higher earnings per share ratio means that a company generates higher profits for each shareholder. However, these do not represent distributed profits. The formula for earnings per share is as follows.
Earnings Per Share = Net Income / Number of Outstanding Shares
Return on Capital Employed
The Return on Capital Employed (ROCE) ratio compares a company’s profits with its capital. It measures a company’s efficiency in creating profits for the given funds invested in it. Capital employed consists of a company’s equity and non-current liabilities. Similarly, investors can calculate a company’s capital employed by deducting its current liabilities from its total assets.
A higher ROCE shows a company’s efficiency in generating profits for the given funds invested in it. A lower ROCE may show problems within the company’s operations. The formula for ROCE is as follows.
Return on Capital Employed = Net Income / Capital Employed
As mentioned, given below is the formula for capital employed.
Capital Employed = Total Assets – Current Liabilities OR Equity + Non-current Liabilities
Profitability ratios are crucial for investors and stakeholders looking to evaluate a company’s performance. Usually, investors prefer companies with high profitability ratios. They can use various ratios such as profit margin, earnings per share, or return on capital employed, among other options.