Importance and limitation of Profitability Ratios (All You Need to Know)

Overview:

Profitability ratios are a group of quantitative values that measure a company’s profitability against its revenue, cost of sales, equity, and balance sheet assets. It is a metric that measures a company’s ability to generate income from its operations over a specific period of time.

A profitability ratio is a category falling under financial ratios that are used by investors, bankers, financial institutions, creditors, and other stakeholders for evaluation of the financial performance of the company in regards to annual profitability.

These ratios help them to assess how profitable an entity currently earns from using or managing the existing resources to generate profits and add value to its shareholders or owners.

For example, the gross profit margin is the ratio used to assess how efficiently the company manages its costs compared to its competitors or industry averages.

If the margin is high competitors’, it means that the company could generate a high profit from 1USD that it spends compare to competitors or industry averages.

Even though these ratios are important for most key stakeholders, those ratios themselves also have limitations.

In this article, we will discuss the key importance and limitation of profitability ratio that might help analysts or users for their interpretation and usages.

But, before heading to the key importance and limitation, let see the list and formula of ratios first.

List and Formula:

The following is the list of a few ratios that are included in the category of profitability ratios:

Gross profit margin ratio = (Gross Profit / Revenue) * 100

Net profit margin ratio = (Net Profit / Revenue) * 100

Return on equity = (Profit after tax / Shareholder’s equity) * 100

Return on capital employed = Profit before interest and tax / (Total assets – current liabilities)

Return on assets = Profit before interest and tax / Total net assets

A high profitability ratio as compared to the previous year’s performance or the industry, in general, is an indication of improvement in the profits earned by the company.

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On the contrary, though, a low profitability ratio as compared to the previous year’s or the industry, in general, is an indication of a reduction in profits earned in the current year.

Importance of profitability ratios:

Here, we will discuss the significance of the profitability ratio in terms of each ratio mentioned above.

• Gross profit margin is a measure of the profit earned on sales. It denotes the profit part of the total revenue earned after deducting the costs of goods sold. It is significantly important since the gross profit is what covers the admin and office costs and the dividends to be distributed to the shareholders. The higher the gross profit the more profitable the company is and is a good catch to invest in. As mention above, it is also used to assess the efficiency of cost management. If the calculation shows that the ratio is now, then the key areas to look or improve are purchasing as well as productions in terms of economy and effectiveness.
• The net profit margin is the final ratio that demonstrates the overall performance of a company. We could say that it is the most important ratio for the management since any disturbances in other ratios indirectly hit the net profit margin as well. For example, a low quick ratio may be because of low sales which would obviously lower the net profit margin as well. This ratio is important since it could help the company or investors to see where it could go wrong in the company’s current operating expenses. Maybe the interest expenses are too high due to the financing strategy that weighs more to loan rather than equity.
• Where the net profit margin is an important metric for the company itself, returns on equity are one of the most important ratios for the investors. It is a percentage of the earnings the shareholders get in return for the money invested in the company. The higher the ROE means the higher the dividends the shareholders will receive and hence, more investors are attracted.
• Returns on capital employed (ROCE) measures how efficiently the company uses its assets. It helps the management minimize inefficiencies by evaluating the ROCE ratio. The higher the ROCE as compared to other industries, the higher the efficiency in the production process of the company.
• Return on assets (ROA) is a measure of every dollar of income earned on every dollar of the asset owned by the company. It is similar to the ROCE and helps the management in managing the utilization of assets.
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Limitations of profitability ratios:

• The profitability ratios like, the net profit margin is not an “evergreen” ratio that can be used to compare profitability amongst various industries. For example, a tech-savvy company has a higher net profit margin compared to a bakery.
• The value of investment and profit can easily be manipulated to increase or decrease the profitability ratios as per their needs which can be misleading for the investors and stakeholders.
• The ratios are dependent on several calculations made behind each value reported on the financial statements. A material error or fraud in a line item will result in a miscalculated ratio which would be hazardous for investors and companies in the future.
• Ratios may also be high or good due to the chance factor and hence, shouldn’t be followed religiously. The context behind ratios must always be checked to confirm with the analysis.