Profitability Ratios

Profitability ratios tell a story about a company’s ability to retain as much of its revenue as possible at the end of a financial year in the form of net profit. The ratios give an indication of how efficient a business was with regard to spending money to generate its sales revenue. In this category of ratios, the net profit both before and after tax and interest, gross profit and expense line items are compared to the sales revenue number to determine how much of the revenue generated gets saved or spent.

High profitability ratios can indicate that your business is being efficient with how it spends its money and is able to retain a large portion of the sales revenue generated as net profit. That is, if the net profit amounts are analyzed in relation to sales revenue. If the expenses are analyzed in relation to the sales revenue, then you would want that percentage to be on the lower side. In this scenario it indicates that a small portion of your money is being spent on the specific expanse line item.

The five most commonly used profitability ratios are the gross profit margin ratio, net profit margin ratio, operating profit margin ratio, return on total assets and return on shareholders’ equity ratio.

 Gross Profit Margin Ratio = Gross Profit / Sales Revenue

The gross profit margin ratio indicates what percentage of your sales revenue is retained after the business pays all of its direct costs to generate that sales revenue.

Net Profit Margin Ratio = Net Profit After Tax / Sales Revenue

The net profit margin ratio reveals what percentage of your sales revenue is retained after the business pays all of its business expenses and income taxes for the financial year. A company that has a higher net profit margin percentage compared to its competitor will be viewed as a more efficient, flexible business that is capable of growing. This will be a positive sign for investors and lenders.

Operating Profit Margin Ratio = Net Profit Before Tax, Interest Paid and Depreciation / Sales Revenue

This ratio is very similar to the net profit margin ratio except that it is analyzed using the net profit before taxes, interest expense and depreciation. The reason why this is done is to isolate the profit that is generated from the business operations itself. Depreciation is a non-cash, straight-line expense. Interest expense is a function of the financing decisions of the business owner. It does not reflect the core operations of the business. Similarly, taxes are determined by the government and business have no control over how much of their hard-earned profits goes to the government coffers.

Return On Assets Ratio = Net Profit After Tax / Total Assets

The return on assets ratio shows how well a business’s assets are being put to work. In other words, it is an indicator of how efficient a business is using their assets to generate revenue. Usually, the higher the percentage, the better. However, comparison must be made with similar types of businesses. A capital-intensive entity such as a manufacturer will generally have a lower return on assets since they need large investments in machinery to conduct business. Contrarily, a consulting business will have a higher return on assets because it does not need a large investment in tangible assets.

This ratio can also be analyzed using the gross profit and net profit before depreciation and interest amount to gauge how well your assets are being used at various points in the business’s operations.

Return On Equity Ratio = Net Profit After Tax / Shareholders Equity

This ratio is similar to the return on assets ratio except that it measures the performance of the business relative to the investments made by the business owners themselves. The return on equity indicates if the business owners’ contributions are being used efficiently to generate long-term wealth for the owners. This percentage will be compared to other investments. If the return on equity is higher in comparison to other investments, the business owner will feel that he is getting a good reward for risking his money and gambling on opening a business. A higher return on equity percentage is also favorable for attracting more investors in the future.