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 

 

   

 

Debt Management Ratios

 

Debt management ratio is a financial ratio which indicates the level of debt financing in an organization. Naturally an organization may not always have all the funds it needs to operate. So what it does is borrow from lenders for short term and fulfill its obligations. After this, it generates profit  from business and pays to these lenders in time. It is crucial to manage the level of debt financing because too much debt leads to too much interest payment. So it affects profitability. To mitigate this, a company makes a policy of borrowing only to certain percentage. Further, it also calculates several ratios to understand the situation of debt financing and decide accordingly. These ratios are as follows:

1. 1.       Debt Ratio: Debt ratio signifies the share of total debt in total assets. If the share is very high, then it can be trouble for a company because it leads to too much interest payment. Thus, the profit of company will shrink. Also, in such case creditors may not lend further. Therefore it creates trouble for the operation in a company.

Mathematically,

Debt ratio= Total Debt/ Total Assets

Naturally debt ratio shows the parts total debt comprises in total assets. So it gives an early warning to managers to stop financing by debt. Also it gives prior warning to investors to stop lending because a company may not be able to pay.

Example of Calculation

What is the debt ratio of a company with 100 million in total debt and 200 million total assets.

Solution;

Total Debt = 100 Million

Total Assets= 200 Million

Debt ratio= Total Debt/ Total Assets= 100 Million/200 Million = 1/2= 0.5

This ratio can be compared to company standards to determine whether the ratio is higher or not.

 

2.      Debt- Equity Ratio:  Debt equity ratio is the ratio of total debt to total equity. In calculating this, it shows the share of total debt in total equity. We add long term debt and current liabilities to determine the value of total debt. Whereas, total equity includes equity capital, preference share capital and undistributed profits. So debt-equity ratio shows the long term solvency position of a company.

The higher the debt equity ratio, the higher a company is debt financed. As explained in earlier topic, in such case an organization has to pay more interest and so its profits becomes low. If an organization takes huge loan, a very big amount needs to be paid as interest. Thus this situation should be avoided.

It is generally safer for an organization to increase shareholders equity. This is because they don’t have to pay interest on it and also it don’t affect profitability.

Mathematically,

Debt-Equity Ratio= Total Debt / Total Equity

For eg: Calculate the debt-equity ratio of a company having total debt 5 million and total equity of 20 million.

Solution;

Total debt= 5 million

Total Equity = 20 million

Debt-Equity ratio = 5 million/20 million =  0.25

This value should be compared to industry standards to determine if the ratio is higher or not.

 

3.      Long Term Debt to Total Assets Ratio: This is another measure of the solvency position of a company. It is calculated by dividing long term debt with total assets. It also indicates the leverage position of a company, but in case of long term debt and not in case of total debt.

Mathematically,

Long Term Debt to Total Assets Ratio= Long Term Debt/ Total Assets

For example: Calculate the long term debt to total assets ratio if the long term debt is 300 million and total assets is 400 million.

Solution,

Long term debt= 300 Million

Total Assets= 400 Million

Long term debt to total assets ratio = Long term debt / Total Assets= 300 Million/ 400 Million = 0.75

 

4.         Equity Multiplier: Equity multiplier is calculated as the ratio of Total Assets to Total           Equity. So it shows how much times total assets is greater than total equity.

           Mathematically,

           Equity Multiplier= Total Assets/Total Equity

           It can also be used to calculate debt ratio.

           Debt ratio= 1-1/Equity multiplier

           Thus if the equity multiplier is high, the debt ratio is higher. And if the equity multiplier                     is lower, the debt financing is lower.

           It becomes necessary to calculate equity multiplier because it shows how much                             percentage of total assets is financed by total equity.

           For Example: Calculate the equity multiplier if the Total Assets is 250 million and Total                    equity is 150 million.

           Solution,

           Total Assets = 250 million

           Total Equity= 150 million

            Equity Multiplier= 250 million/ 150 million= 1.66

            It shows total assets is 1.66 times total equity.

 

5.      Times Interest Earned Ratio:. As discussed earlier, a company manages its fund through debt financing and equity financing. It is crucial for a company to pay its annual interests because it creates credibility among lenders. Thus, times interest earned ratio is calculated to understand the ability of a company to pay its interest obligations. In this case, higher ratio indicates that a firm can pay its annual interest easily whereas lower ratio shows it will be difficult for a firm to pay its annual interest payment.

Mathematically,

TIE ratio = EBIT/ Interest Charges

For example: Calculate the TIE ratio if a company has EBIT of 100 million and Interest charges of 25 million.

Solution,

EBIT= 100 Million

Interest charges= 25 million

TIE ratio = 100 Million/ 25 Million = 4 times.

 

6.      Cash Coverage Ratio: It is the ratio of cash available in the firm to pay its borrowers to total interest charges. To calculate total cash available, we sum earning before interest and taxes with depreciation. This is because EBIT show the amount of cash available before payment of interest and taxes. Also depreciation is a provision and its cash amount is hold in a company. Thus they are cash reserves.

Higher ratio show that a company can easily fulfill its interest payment obligations and lower ratio shows a company will face difficulty to pay its interest obligations.

            Mathematically,

            Cash coverage ratio = EBIT+ Depreciation/ Interest charges

            For example: Calculate the cash coverage ratio if EBIT is 50 Million and depreciation is                              1 Million. Further the interest charges is 20 million.

            Solution,

            EBIT= 50 Million

            Depreciation = 1 Million

            Interest Charges= 20 Million

            Cash Coverage ratio = EBIT+ Depreciation/ Interest Charges = 50 mil + 1 mil/ 20 mil=                                                                                                          51/20 = 2.55

 

7.   Fixed Charge Coverage Ratio :  An organization leases its unused assets to other                        companies for earning. Further they also take assets on lease from other companies. Also            they have sinking fund payment associated with debt. Sinking funds are the funds that are            accumulated on regular intervals for payment obligations which may arise in the future.

      Mathematically:

Fixed Charge Coverage Ratio = EBIT+ Lease Payments

                         Interest Charge+ Lease Payments+ (Sinking fund payments/ 1- tax rate)

 

The higher the ratio, the better the capacity of an organization to pay its fixed charges. The lower the ratio, the difficult it is for a company to pay its fixed charges.

For Example: Calculate the Fixed charge coverage ratio of a company with EBIT 50 million, lease payments of 2 million, sinking fund payments of 0.5 million and tax rate off 30 percent.

Solution,

 EBIT= 50 Million

Lease Payment= 2 million

Interest charge= 10 million

Sinking funds payment = 0.5 Million

Tax rate= 30 Percent

 Fixed charge coverage ratio= (50+2)/(10+2+(0.5/1-0.3))= 52/(12+0.71) = 4.09 times

 

8.      EBITDA Coverage Ratio: It is the ratio of sum of EBITDA and lease payments divided by the sum of Interest, Principal Payments and Lease Payments. Generally this ratio is developed by Bankers to minimize the deficiencies of TIE ratio. While calculating this ratio, increasing ratio is considered favorable which shows the companies capability to pay the fixed charges.

Mathematically,

 EBITDA coverage ratio= (EBITDA+Lease Payments)

                                       ( Interest+Principal Payments+ Lease Payments).

 For eg: Calculate the EBITDA coverage ratio if EBITDA is 50 million, Lease payments   of 5 million, Interest of 2 million and principal payments of 1 million.

 Solution,

 EBITDA= 50 million

 Lease Payments= 5 Million

 Interest= 2 Million

 Principal payments= 1 million

 EBITDA= (50+5)/(2+1+5)=55/8=  6.875 times

 

Further Reads 

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

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