Profitability Ratios are the group of Financial Ratios that use for assessing and analyzing the entity’s profitability through various ratios. The areas that these ratios focus on are sales performance, costs management, assets efficiency, and sometimes cash flow management. The high or increase of these ratios implicitly means the entity financial performing well. The high or increase of these ratios implicitly means the entity financial performing well.
These ratios are normally included whether assessing and 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 investments analysis, we normally use some of theses ratio along with others ratios and non-financial indicators to measure and assess the performance, financial position of the entity.
In this article, we list all of the Importance Profitability Ratios that you should know along with the 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 Ratios 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 of the entity.
Gross profit margin is calculated by Gross Revenue generates during the period less Cost of Goods Sold. Now, why do we say that gross profit is not just only measure the Profitability, but also Control Cost? Well, most of the cost controller and financial controller use this ratio to analyst how well the company controls its cost compare to the competitors.
let say A and B sell the same product and the same price in the same market. 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 hither cost than B that is why it’s 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 move to detail, the Net Profit Margin is calculated by comparing Net Profit to Gross Sale. So, Net Profit is come up by removing the Gross Profit with corresponded 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 of the financial analysts when they analyze the Net Profit Ratios, they want to assess Operating Expenses.
For example, if the company got better Gross Profit Ratios, then the main reason is their operation is not effective and efficient. As a result, reviewing the operating activities is the most recommended.
Yet, just recommending to review the current operation is not what most of the management need. You need to do deep recommendations by doing deep analysis. For example, breakdown the main expenses items and review them if there any room to improve.
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.
Let move to detail.
Let talk about a suitable situation to use this ratio.
Return on Assets is right for the Production company that most of its assets are fixed assets, and it is not right to use in the service company like audit firms.
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 Asset, 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 old and 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, the ratios will be increased when the assets become old as the result of management intention not to replace them.
Therefore, use 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 the fund that investors injected their investment found into the project or company.
In most of the case, Return on Investment is used to assess the investment project or products the company launch 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 than.
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 to 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 buy 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. The two main importance items in this ratio are Net Profits and Shareholders’ Equity.
ROE is the ratio that mostly concerns by shareholders, management teams, and investors. Most of the investors use this ratio to assess the profitability of the entity and for consideration whether they should buy shares from the entity or not.
However, there are many augment about this ratio to be used as the main indicator for investing decisions. The main reason is this ratio could be manipulated by the entity.
Why are the profitability ratios so important?
Profitability ratios are calculated and assess 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 key performance indicators, you might find most of them are on the list of KPI.
So that means to meet the performance that set, management needs to make sure the ratios run-up to the target. Mostly, these ratios are calculated and track monthly so that they could 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, the mean the entity might not find difficult to pay back the loan, and credits. Also, investors and shareholders will receive the stratify return on their investments.