Definition:
Profitability Ratios are the group of Financial Ratios used to assess and analyze the entity’s profitability through various ratios. These ratios focus on sales performance, cost management, asset efficiency, and sometimes cash flow management.
The high or increase of these ratios implicitly means the entity is financially performing well. The high growth of these ratios implicitly means the entity is financially performing well.
These ratios are normally included whether assessing or analyzing profitability ratios:
- Gross profit margin
- Net profit margin,
- Return on assets,
- Return on investment,
- Return on capital employed and
- Return on equity.
In performance management, performance assessment, and/or investment analysis, we normally use some of these ratios along with other ratios and non-financial indicators to measure and assess the performance and financial position of the entity.
In this article, we list all of the Importance Profitability Ratios that you should know, along with a deep analysis of individual ratios.
By the end of this article, you should be able to understand and be able to interpret six important profitability ratios. We explain the principle of each ratio, including the formula and all important factors that you should know.
Here is the detail of each Profitability Ratios for Financial Analysis:
Gross Profit Margin:
Gross Profit Margin is the Profitability Ratio that use to assess the proportion of gross profit over the entity’s net sales. The main purpose of this ratio is to control the gross profit or cost of goods sold by the entity.
Gross Revenue calculates the gross profit margin generated during the period less the Cost of Goods Sold. Now, why do we say that gross profit is not only measuring Profitability but also Control Cost?
Well, most cost controllers and financial controllers use this ratio to analyze how well the company controls its cost compared to the competitors.
Let’s say A and B sell the same product and the same price in the same market. The Gross Profit Margin of A is 50%, and the Gross Profit Margin of B is 60%.
Since it is the same product, we expected that both companies should have the same cost. But in this example, A must spend cost than B hither, which is why its Gross Profit Margin is smaller than.
Net Profit Margin:
Net Profit Margin is one of the Profitability Ratios that use to measure and assess the proportion of an entity’s net profit after reducing the operating expenses. Another main purpose of the Net Profit Margin is to control company Operating Expenses.
Let’s move to detail, the Net Profit Margin is calculated by comparing Net Profit to Gross Sales. So, Net Profit is come up by removing the Gross Profit with corresponding operating expenses.
If we first look at this ratio, I think you will come up with the idea that this ratio is used to measure the net profit. But it is not the case.
This ratio is just like Gross Profit Ratio. It comes up as the result of the financial performance indicator, and most financial analysts, when they analyze the Net Profit Ratios, want to assess Operating Expenses.
For example, if the company got better Gross Profit Ratios, then the main reason is its operation is not effective and efficient. As a result, reviewing the operating activities is the most recommended.
Yet, just recommending to review of the current operation is not what most of the management need. You need to make deep recommendations by doing deep analysis. For example, break down the main expense items and review them to see if there is room for improvement.
Return on Asset or Return on Fixed Asset:
Return on Assets or Return on Fixed Asset is one of the Profitability Ratios that use to assess the level of profit that assets could generate.
Still, doubt?
Right?
Let’s move to detail.
Let’s talk about a suitable situation to use this ratio.
Return on Assets is right for the Production company because most of its assets are fixed assets, and using them in a service company like an audit firm is not right.
Why?
Because this ratio is used to measure the performance of the assets in terms of profit.
When you interpret Return on Assets or Return on Fixed Assets, you are not only saying about the result of your calculation, but the nature of assets (How old the assets are? ), and probably, staff using the assets.
The performance of assets is not mainly because of the assets themselves. What if the assets are sold, management does not replace the spare part, and the maintenance schedule is not right?
Return on Fixed Assets is very important to use with Return on Capital Employed if you set up the Financial Performance Indicators for your company.
The main reason is when you use the Return on Capital Employed in Performance Measurement, and the ratios will be increased when the assets become old due to management’s intention not to replace them.
Therefore, using both Return on Fixed Assets and Return on Capital Employed will help you to balance.
Return on Investment
Return on Investment is one of the Profitability Ratios that use to assess the profitability that generates from the investments for the period of time from total investments found.
The investment fund is where investors inject their investment into the project or company.
In most cases, Return on Investment is used to assess the investment project or products the company launched rather than assess the performance of an entity.
If we want to assess the performance of the entity, then ROC or ROE would be better to use and the most relevant.
Return Capital Employed
Return on Capital Employed is one of the Profitability Ratios that use to assess the profit that the company could generate for its shareholder’s capital employed. Capital employed is the fund that shareholders inject into the company plus other capital and long-term debt.
Capital employed can be calculated by total assets less current liabilities. Sometimes, the entity wants to improve this ratio by using old assets to pay a dividend by using load and buying back shares.
Return on Equity
Return on Equity (ROE): is one of the Profitability Ratios that use to measure how much profit an entity could generate from shareholders’ Equity. Net Profits and Shareholders’ Equity are the two main important items in this ratio.
ROE is the ratio that mostly concerns shareholders, management teams, and investors. Most investors use this ratio to assess the entity’s profitability and consider whether they should buy shares.
However, there are many augment about this ratio to be used as the main indicator for investing decisions. The main reason is the entity could manipulate this ratio.
Why are profitability ratios so important?
Profitability ratios are calculated and assessed by both internal stakeholders and external stakeholders. These ratios are so important to management, especially their performance, that assigns the board of directors.
If you look at the ratios again and check with your entity’s key performance indicators, you might find most of them are on the list of KPIs.
So that means to meet the performance that is set, management needs to make sure the ratios run up to the target. Mostly, these ratios are calculated and tracked monthly so that they can make sure they have enough time to fix.
Not only internal stakeholders but also external stakeholders like bankers, creditors, investors, and shareholders are very serious about these groups of ratios.
If these ratios look good, that means the entity might not find it difficult to pay back the loan, and credits. Also, investors and shareholders will receive a stratified return on their investments.
How to Improve Profitability Ratios?
Profitability ratios are an essential component of financial analysis, and they provide a comprehensive overview of a company’s ability to generate profits.
Profitability ratios help investors, managers, and other stakeholders to evaluate a company’s financial performance and determine its growth potential.
To improve profitability ratios, companies need to take a strategic approach that involves analyzing financial data, identifying areas for improvement, and implementing appropriate strategies.
In this article, we’ll outline some key steps companies can take to improve their profitability ratios.
Increase Revenue
The most obvious way to improve profitability ratios is to increase revenue. Companies can expand their customer base, launch new products, or enter new markets.
In addition, companies can increase revenue by improving their pricing strategies, optimizing their sales processes, and increasing their marketing efforts.
Reduce Costs
Another way to improve profitability ratios is to reduce costs. Companies can do this by identifying areas of inefficiency and waste and taking steps to eliminate them.
For example, companies can streamline their operations, negotiate better pricing with suppliers, and implement cost-saving measures such as energy-efficient equipment and reduced travel expenses.
Improve Gross Margin
The gross margin ratio measures the difference between a company’s revenue and its cost of goods sold. A higher gross margin indicates that a company generates more profit from each sale.
To improve their gross margin, companies can reduce their cost of goods sold by negotiating better pricing with suppliers, improving their production processes, and reducing waste.
Increase Operating Efficiency
The operating efficiency ratio measures a company’s ability to generate profits. Companies must focus on improving their productivity and reducing operating expenses to improve this ratio.
This can be achieved by implementing lean production techniques, reducing inventory levels, and improving supply chain management.
Increase Asset Turnover
The asset turnover ratio measures a company’s ability to generate revenue from its assets. Companies must focus on maximizing their assets’ use to improve this ratio.
This can be achieved by reducing idle time, improving equipment utilization, and optimizing inventory levels.
Manage Working Capital
Working capital management is critical to a company’s profitability. Companies must ensure sufficient cash flow to meet their obligations while minimizing the working capital tied up in inventory and accounts receivable.
Companies can implement effective cash management strategies to improve working capital management, negotiate favorable payment terms with suppliers, and improve their collection processes.
Profitability Ratios Limitation
Profitability ratios are financial metrics that measure a company’s ability to generate profits from its operations. These ratios are commonly used by investors, analysts, and managers to evaluate a company’s financial performance and potential for growth.
However, profitability ratios have limitations that must be considered when interpreting financial data. In this article, we’ll discuss some of the limitations of profitability ratios.
Limited Scope
Profitability ratios provide a snapshot of a company’s financial performance at a specific time. However, they do not provide a complete picture of a company’s financial health.
Profitability ratios do not consider factors such as liquidity, solvency, and financial stability, which are critical to assessing a company’s long-term viability.
Industry and Business Model Differences
Different industries and business models have different profitability norms. For example, a company operating in a highly competitive industry may have lower profitability ratios than a less competitive industry.
Similarly, a company with a high level of capital investment may have lower profitability ratios than a company with lower capital investment requirements. Thus, comparing profitability ratios within the same industry and business model is essential.
Accounting Policies and Practices
Accounting policies and practices affect profitability ratios, which can vary from company to company. For example, companies may use different methods of calculating depreciation, which can affect their profitability ratios.
Companies may also have different policies for recognizing revenue, which can affect their gross margin ratio. Thus, it is important to understand a company’s accounting policies and practices when interpreting its profitability ratios.
Temporary Effects
Profitability ratios can be affected by temporary events that may not reflect a company’s financial performance. For example, a company may experience a one-time gain or loss that affects its profitability ratios.
Similarly, a company may change its capital structure, affecting its profitability ratios. Thus, it is essential to understand the reasons behind any significant changes in a company’s profitability ratios.
Limited Usefulness for Startups
Profitability ratios may not be useful for startups or companies in the early development stages.
Startups often incur significant expenses in the initial stages of their operations, which can result in negative profitability ratios.
Thus, other financial metrics such as burn rate, cash flow, and customer acquisition cost may be more relevant for assessing the financial health of startups.
