Profitability Ratios

Profitability ratios are financial ratios which measure the profit making capacity of a company. In the task of doing business, a company undertakes various nature of jobs. These all are called operating tasks of a company. Profitability ratios summarizes if all these operating tasks can generate profit or not. To define, “profitability ratios are a group of ratios which show the combined effects of liquidity, asset management and debt management on operating results”.

There are six types of profitability ratios.

1.      Net Profit Margin: Net profit margin is the measure of how much a company has earned per rupee of sales or revenue. It is a crucial measurement ratio because it highlights whether a company is in profit or loss. Investors analyze this ratio to take decision to further invest in a company. Whereas managers take account of this ratio to determine whether a company will be in profit or loss in a certain fiscal year. Thus, it gives them a time for self- improvement.

Mathematically,

Net Profit Margin= Net Income/Sales

A higher net profit margin is beneficial for a company as it indicates strong profitability and efficient operations.. Whereas, decreasing ratio signals that the company is struggling to generate desired profit.

2.      Gross Profit Margin: It is the ratio which shows the share of gross profit in sales. The calculation of gross profit is done by substracting cost of goods sold from sales. Additionally, gross profit is calculated as a percentage of total sales.

Mathematically,.

Gross Profit Margin = Gross Profit/ Sales = (Sales- Cost Of Goods Sold)/ Sales

When analyzing, the increasing ratio is considered good because it shows the profit making capability of the company is high. Alternatively, the decreasing ratio shows the company is wrestling for desired profit.

3.      Operating Profit Margin: The operating profit margin ratio helps to understand profitability by calculating the ratio of EBIT and sales. This calculation reveals the percentage of operating profit within an organization. This operating profit can be used for office expenses once deducted for Interest and Taxes. 

Mathematically, operating profit margin is calculated as:

Operating profit margin= EBIT/ Sales

The calculation of EBIT is straightforward. To calculate its value, all the variable costs are deducted except interest and taxes. Once interest and taxes are deducted, it becomes net profit.

While analyzing,  the higher the value of this ratio, the better a company is managed. Whereas, The lower the ratio, the more it points to ineffective company management.

4.      Basic Earning power: Earning power can be defined as “The power of a company to make profit over a long term”. For this, we calculate Basic Earning Power ratio. It is the ratio of EBIT and Total Assets. In short, it shows how much profit the company earns from its total assets.

Mathematically, Basic Earning Power can be calculated as;

Basic Earning Power = EBIT/ Total Assets

As explained earlier, EBIT is the Earning Before Interest And Tax. Whereas Total Assets can be calculated as the sum of Current Assets and Non-Current (Fixed) Assets. Assets expected to be liquidated or used up within a year are classified as current assets. On the other hand, Non Current (Fixed) Assets can take longer than a year to be realized as cash.

5.      Return On Total Assets: Return on Assets (ROA) indicates how effectively a company converts its assets into profit. Thus, It signifies the return generating capacity of a company.

Mathematically,

Return On Total Assets = Net Income/ Total Assets

In the above formula Net Income denotes earning after interest and taxes (EBIT). Total assets denotes Total Current Assets plus Total Long Term Assets.

This ratio is one of the major ratio in profitability analysis and therefore, is extensively utilized by managers and investors. A higher ROA means a company is highly efficient in utilizing its assets and lower ROA means a company is less efficient in utilizing assets.

6.      Return On Common Equity (ROCE): ROCE measures how efficiently a company has utilized shareholder’s funds to generate income. It shows how much net income is being produced with the equity collected from investors. This ratio is of greater importance to managers, higher authority and investors because of its capacity to analyse the situation of their fund utilization Thus, managers and higher authorities can choose to improve their operation. Whereas investors can choose to further invest or not in the future.

Mathematically,

Return On Common Equity (ROCE) = Net income/ Common Equity

While evaluating, the increasing value of ratio is favorable because it shows the money of investors has been utilized properly. Decreasing ratio shows investors equity hasn’t been utilized properly. Further, to know what ratio is desirable, we can compare it with the prevalent industry standards.

All these ratios are very important financial ratios. They need to be evaluated properly by insiders as well as outsiders before making investment decisions.

 

Further Reads 

 https://usefulfinanceforus.blogspot.com/2025/07/profitability-ratios.html

https://usefulfinanceforus.blogspot.com/2025/07/assets-management-ratio.html