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 

 

   

 

Assets Management Ratio

Assets Management Ratio

Assets management ratios are another important financial ratios. They are an indicator of how well a firm is

managing its assets. They are often named as activity ratios or efficiency ratios or turnover ratios. It is crucial for

 an organization to maintain schematic management of Assets because once assets are used, if it doesn’t produce 

profit, will result in loss. Such assets can be lost forever. Thus assets management ratios help in managing such

assets.

Types

1. Inventory Turnover ratio: It is defined as the ratio of Cost of Goods Sold and Average Inventory.  

   It measures the efficiency of utilization of inventory. 

 Inventory Turnover Ratio= Costs of goods sold/ Average Inventory

 Where, we get Cost Of Goods Sold by substracting Gross profit from Net sales.

 i.e Cost of goods sold= Net Sales- Gross Profit

When gross profit is deducted from Net sales, it shows how much the cost (Purchasing cost and production cost )

of goods were incurred. When divided by Average inventory, it shows the ratio of inventory that was sold.

A higher inventory turnover ratio is better because it shows that inventories is being managed very efficiently. A

low inventory turnover ratio shows more investment has been made in maintaining inventories relative to sales. A

higher inventory ratio means there will  be shortage of inventories most of the times and thus needs to be  properly

managed.

Inventory turnover ratio can also be used to find the age of inventory. i.e in how many days inventory is being 

cleared.

Mathematically,

Days of inventory (age of inventory) = Days in a year/ Inventory turnover ratio

2. Receivables turnover ratio: An organization doesn’t always work on direct payment. It works on 

   credit also. Thus receivables are created. Receivables is very important to maintain liquidity and 

   should be collected on time. For this purpose, Receivables turnover ratio shows the ratio of annual 

   sales and average debtors.

  Mathematically: 

Receivables turnover ratio= Annual Credit sales/ Average receivables or debtors

The higher the ratio, the more efficient a company is in the management of collection from debtors. A low ratio 

shows that a company is inefficient in collection.

3. Days sales outstanding (DSO): A company works in cash payment as well as in credit. It becomes crucial to 

collect debt in timely manner for smooth functioning of a company. Otherwise, a company may run short of cash

to pay for its daily needs. Thus to solve this issue, the Days Sales Outstanding is calculated. It calculates a 

company’s ability to collect debt timely. The lower the days sales outstanding, the better a company is collecting

its debts. Also the higher the DSO, the performance of the company in terms of debt collection is worst.

Mathematically,

DSO= Receivables/ Average Credit Sales per day

For example, If the receivables is Rs 500 and average credit sales per day is 50, then 

DSO= 500/50 = 10 days

It shows that the receivables is collected in 10 days. If the credit term is 10 days or lower, then the company is 

managing receivables effectively. But if the DSO is higher than 10, it shows that the company hasn’t been able to

manage receivables properly.

4. Fixed Assets Turnover Ratio: A company should use its fixed assets to generate sales. This helps a company

 to remain in business for a longer term. To find out if a company is utilizing fixed assets to generate sales 

properly, fixed assets turnover ratio is calculated. It is calculated by dividing Sales by Net fixed Assets.

Mathematically,

Fixed Assets turnover ratio = Sales/ Net Fixed Assets

Higher value of this ratio shows that a company is efficient in managing its assets. Whereas lower value shows 

that a company hasn’t been able to manage or make optimal use of its fixed assets. Thus it is one of the major 

factor in ratio analysis.

For example, if sales is Rs 50,000 and Net fixed assets is Rs 25000, then 

Fixed Assets Turnover Ratio= 50000/25000 = 2 

But if sales is Rs 50,000 and Net Fixed Assets is 30,000, then

Fixed Assets Turnover Ratio= 50000/30000= 1.66

 

In conclusion, it shows that the company having Fixed Assets Turnover ratio of 2 is performing better than that 

of the company having ratio of 1.66.

5. Working capital turnover ratio: The working capital turnover ratio calculates how the working capital of a

 firm has been utilized. The working capital is calculated as Total Current Assets less Total Current Liabilities. 

Thus it is the excess value of Current Assets which can be used for other purposes.

Mathematically,

 Working capital turnover ratio = Annual net sales/ Average working capital

It is to be noted that, in the above formula, for higher value of working capital turnover ratio, the value of average

working capital should be lower. Thus, it shows that there is lower investment in working capital and the 

profitability becomes higher. In other case, if there is more investment in working capital, the value of average 

working capital will be higher and the working capital turnover ratio will be lower. Thus, it reflects 

mismanagement.

6. Total Assets Turnover ratio: This ratio shows how a company is utilizing its Total Assets. To calculate this 

ratio we should divide Sales by Total Assets.

 

Mathematically,

Total Assets Turnover Ratio= Sales/ Total Assets

Total Assets is calculated as the sum of Current Assets, Fixed Assets and Investment. Thus the above ratio shows

 how much greater sales is being generated in comparison of assets being employed. The value of this ratio is 

better if it is higher than one because it shows that a company is generating enough sales. A low ratio means a 

company is not performing better.

 

Further Reads 

 

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

 

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

Financial Ratios and Analysis

Financial analysis is the analysis of financial statements for decision making purposes. Financial statements serves 

dual purpose: First it’s used to evaluate a company’s performance by internal staffs. Secondly it’s used to evaluate 

the performance of company by outsiders. Internal staffs appraise financial indicators to improve the performance

 of a company whereas external people evaluate financial indicators to decide for investment. If the financial ratios 

are promising, investors will be willing to invest in a company.

For internal control process, the relationship between financial statements(Income Statement, Balance sheet and 

Cash Flow Statement) should be evaluated. Additionally financial ratios should also be evaluated. Together these 

statements serve as an indicator of performance of a company. Also they serve as a benchmark about how

 competitors are performing in the market. If the ratio is higher, then it may mean that the competitors are doing 

better and vice versa. Thus a company gets a chance to improve itself in time.

Financial ratios are the major tool of financial analysis. They help to find out the systematic strength or weakness 

of a company. Thus they are highly important.

Financial ratios can be grouped into following five types:

1. Liquidity ratios

2. Assets management or efficient ratios

3. Debt management ratio or leverage ratios

4. Profitability ratios

5. Market value ratios

We will now deal one by one with these ratios. Firstly we will understand about liquidity ratios.

 

1.  Liquidity ratios: Liquidity ratios are the major part of financial ratio analysis.The purpose of these ratios is to 

find out the solvency position of an organization. This means whether a company is able to pay its short term 

liabilities or not. Being able to pay short term liabilities is crucial for an organization because it helps to build an 

environment of trust in the eyes of investors. This is important for the smooth running of an organization. The major 

liquidity ratios are:

 

 1.a) Current ratio: Current ratio is one of the major financial ratios. It measures the extent to which current 

liabilities is met by current assets. It is calculated by dividing current assets by current liabilities. Current assets are 

liquid and they can generate money in a relatively short period of time. Thus if the ratio of current assets with current 

liabilities is maintained, it becomes easier for payment. The major current assets are cash, Marketable securities, 

saundry debtors, bills receivable and inventory. The major current liabilities are bank overdraft, saundry creditors, 

bills payable and outstanding expenses.

 But one thing we should be careful about! If current ratio is too high, it means a company is inefficient and 

misutilizing its fund in purchasing too much current assets. But if the ratio is too low, then a company can’t fulfill 

its short term obligations. The standard ratio of current assets can vary country-wise but generally a current ratio of

 2:1 is considered best.

Mathematically: Current ratio = Current Assets/ Current Liabilities

1.b) Quick or Liquid or Acid Test Ratio: The purpose of this ratio is to find out the capacity of a company for

 immediate payment of current liabilities.Thus Quick ratio is calculated by deducting inventories from current assets 

and dividing by current liabilities. Inventories are deducted because it can be difficult to liquidate them at their full

 book value, thus rendering them invaluable for payment of current liabilities.

Mathematically, Quick Ratio= (Current assets- Inventories)/ Current liabilities

We can summarize as:

1. The ratio of 1:1 is considered as an ideal ratio for meeting all current liabilities.

2. The ratio greater than 1:1 indicates that a company is in strong position to fulfill its payment 

   liabilities.

3. The ratio less than 1:1 indicates that a company isn’t in position to fulfill its short term obligations.

Quick ratio is important for investors and managers because it provides a more clear view of liquidity position than 

that of Current Ratio.

1.c) Cash Ratio: This ratio gives an idea whether the most liquid assets can cover the current liabilities. These liquid 

assets are cash and marketable securities. Thus its formula is:

Cash ratio= (Cash + Marketable securities)/Current Liabilities

Cash denotes free cash level which can be easily paid to fulfill liabilities. Whereas Marketable securities can easily 

be sold in the stock market to convert them into cash within a short time frame of one year. Thus when the ratio is 

calculated by comparing current liabilities with cash plus marketable securities, it shows the chances of payment of 

current liabilities.  

• A cash ratio of greater than one means that a company is in better position to pay all of its current 

  liabilities.

• A cash ratio less than one means a company may face difficulties in paying its current liabilities.

1.d) Net Working Capital (NWC) to Total Assets Ratio: It is the ratio of net working capital and total assets. Net

 working capital is defined as the difference of current assets and current liabilities.

Thus first it shows how much the current assets is higher than current liabilities. Secondly it shows the ratio of this 

difference with respect to total assets.

Mathematically: NWC to total assets ratio= Net working capital/ Total Assets

                                                                  = (Current Assets-Current Liabilities)/ Total Assets

• Positive value of NWC to total assets ratio indicates that a company is in good position to pay its 

  current liabilities.

• Higher value of NWC to total assets mean that there is high chances that the short term obligation 

  be met

• Lower value of NWC to total assets mean that there is less chance that the short term obligation 

  be met.

• Negative value indicates that there will be difficulty to met the short term obligations.

Together Financial ratios are a major part of financial planning and analysis. They help in performance analysis as 

well as investment analysis. Thus they are used extensively for interpretation purpose.

 

Further Reads

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

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

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