Profitability Ratios: Definition, Types and Use in Businesses
Profitability Ratios are most important metrics used for financial analysis of a company and its business. Profitability ratios show how profitable a company and its business at different levels of profitability. Profitability ratios determine that is a company worthwhile to invest or not.
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The insights of these ratios are useful when it is compared with historical trend of a company itself and its peers. In other words, these ratios for a company gives valuable insights for decision making when a company is compared with industry peers, or historical data of itself. It is better to compare for same period such as – comparison of a year’s first quarter with the first quarter of the previous year to measure quarterly change on YoY (Year-on-Year) basis. Consecutive quarters are also compared to know the change.
For example: Let’s say a hypothetical telecom service provider company X can be compared with other players of telecom industry. And, the current year’s insights of company X can be compared with its past trend to its present performance.
Furthermore, outcomes of ratios of Company X can be compared with other players of same industry to learn that which company is better for investment. Profitability ratios are useful for investors, lenders, research analysts and others who are willing to invest in a company and its business. Profitability ratios indicate that how well a company and its management operating business.
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Types of Profitability Ratios –
There is some important profitability ratios are:
Gross Profit Margin
EBITDA Margin (Earnings Before Interest, Taxes, Depreciation and Amortization)
Operating Profit Margin or EBIT Margin
Pre-tax Margin
Cash Flow Margin
Net Profit Margin
Return on Equity
Return on Assets
Return on Invested Capital (ROIC)
Return on Capital Employed (ROCE)
Some experts and books describe the aforementioned ratios into two categories, such as – from 1 to 6 into Margin Ratio, and from 7 to 10 into Return Ratios. Margin ratios help to analyse a company’s profitability at different levels, and return ratios help to understand that how well a company generates return for its shareholders.
Gross Profit Margin also known as the simple Gross Margin, it is the difference between revenue and cost of sales. Cost of sales is cost of goods sold (COGS) and/or cost of services sold (COSS). The cost of sales is one of the major expense for a company. Analysts determine by gross profit that what a company have after deduction of the direct cost of sales to pay its obligations such as – operating expenses, interest and taxes.
Increasing gross profit margins may indicate that company’s good control on COGS/COSS and company may also have monopoly in the market, while declining gross profit margin may be an indication that company is losing its market, its reasons may be several. The revenue of some businesses during a specific season such as gold and jewellery related business often see a hike during a wedding season and festivals.
Formula:
Gross Profit = Revenue – Cost of Sales Gross Profit Margin (%) = [(Gross Profit X 100) is divided by Revenue] %
Example:
If the revenue for a year of company X is 1 crore and its COGS is 55 lakhs, so according to formula, the gross profit is 45 lakh (1 crore – 55 lakh) and gross profit margin is 45%.
2. EBITDA Margin:
The EBITDA Margin is computed after deducting the operating expenses from gross profit but with addition of depreciation and amortization. If there are some inventories to write-offs, it is also deducted from gross profit. Interest payment and inventory write-offs are considered non-operating expenses. Operating expenses include the expenses related to sales, general, administrative, R&D (Research & Development), marketing and other indirect expenses.
Depreciation and Amortization expenses are non-cash expense; it is also known as non-cash operating expense or special type of operating expense. Depreciation and Amortization expenses impact the company’s income-statement but actually don’t take place into company’s cash-flow statement, to wit, the depreciation and amortization expense take place into company’s income-statement and affect its bottom line (net profit) but actually cash doesn’t go out from business, therefore, depreciation and amortization expenses don’t take place into cash flow statement; the cash of depreciation and amortization expenses remain into business. But depreciation and amortization expenses reduce the value of company’s long-term assets on company’s balance sheet. The bigger the expense for depreciation and amortization, the bigger the impact of these expenses on company’s net profit.
If operating expenses of company X were 18 lakh and depreciation and amortization expenses were 2 lakh, so according to formula the EBITDA of company X is: INR 29 lakh (45 lakh – 18 lakh + 2 lakh), and EBITDA Margin: 29%.
3.Operating Profit Margin:
Operating Profit is also known as Operating Income or EBIT (Earnings Before Interest and Taxes). Operating profit is the sum of other net-income and the part of the company’s revenue before the interest and tax payment. A company with higher operating profit margin is considered good, but just a single ratio can never determine the investment decision. it’s necessary to see a complete picture and do in-depth analysis of company before investment.
Formula:
Operating Profit Margin (%) = [(EBIT X 100) divided by Revenue] %
Example:
From above number 2, the EBITDA of company X was 29 lakh and depreciation, and amortization were 2 lakh, if there is no other net-income of company X, so operating profit of company X is: EBITDA – Depreciation & Amortization, that is, 29 lakh minus 2 lakh = 27 lakh. Therefore, according to formula the operating profit margin for company X is 27%.
4. Pre-Tax Margin (PBT Margin):
This is also one of the most important profitability ratios of a company, it is computed after interest payment from operating profit. Pre-Tax margin is also known as Profit Before Tax (PBT) Margin.
Formula:
PBT Margin (%) = [(Operating Profit minus Interest Expenses) X 100 divided by Revenue] %
Example:
Assume that the interest expense of company X is 1 lakh, therefore, according to formula the PBT (Profit Before Taxes) of company X is 26 lakh (27 lakh – 1 lakh), and PBT Margin (Pre-tax Margin) of company X is 26%.
5. Cash-Flow Margin:
The cash is the lifeblood of every business. If a company is very good and making a good net-profit on income statement; and management is also doing well and company has consistent growth, but cash isn’t coming into business, this means company is not good to convert its net profit into cash. Ultimately, the business will be in trouble; it may also bankrupt, no matter how management and business were good.
The Cash-Flow Margin also known as Operating Cash-Flow Margin. It helps to assess how efficient a company to convert core-revenue (revenue from operating activities) into cash. If company doesn’t have a significant amount of cash, it is the indication of problem, as the company will face problems to pay creditors (trade payables), lenders, CAPEX (Capital Expenditures) and dividends etc. The need of borrow funds may be arise in case of negative cash-flow, it doesn’t matter that company’s business is generating good revenue from operations on income statement.
Formula:
Cash-Flow Margin (%) = [(Cash-Flow from operating activities X 100) divided by Revenue] %
6. Net Profit Margin (NPM):
The Net Profit Margin is also known as PAT Margin (profit after tax margin). It helps to assess the company’s ability to convert revenue (top line) into net profit (bottom line). The net profit margin tells the revenue’s take-home part after paying all expenses and obligations. Some analysts also prefer to say this as a Bottom-Line Margin. But the main problem with the Net Profit Margin is that it doesn’t give true insights in isolation. It is affected by money related each activity, such as:
Company may write-off some part of trade receivables (account receivables), or
Company may report an unexpected loss by fire, theft or any other unfavourable situation, or
Company may sell any asset, or
Company may get a stucked fund as a settlement of full payment, etc.
Therefore, it’s a wise idea to look at other levels of profitability, such as – gross profit, EBITDA, operating profit, PBT, operating cash flow and other levels of cash flow to make an investment decision.
Formula:
Net Profit = Profit Before Tax (PBT) – Total Tax
Net Profit Margin (%) = [(Net Profit X 100) divided by Revenue] %
Example:
If the net profit of company X is 19 lakh so according to formula the Net Profit Margin of company X is 19%.
7. Return on Equity (ROE):
The ratio is used most widely to assess the company’s ability to generate return on shareholder’s fund. This ratio is affected in both cases – loss or profit. The ROE decreases if company reports net loss, and it increases if company reports net profit. In some cases, the ROE may be higher if a major part of company’s assets are funded by debt. That’s why, a complete analysis is necessary to make an investment rather than rely on a single ratio.
Formula:
Return on Equity (%) = [(Net Profit X 100) divided by Shareholder’s Equity] %
8. Return on Assets (ROA):
The Return on Assets ratio is used to assess that how well a company to generate net profit by using and deploying its assets.
Formula:
Return on Assets (%) = [(Net Profit X 100) divided by Total Average Assets] %
Total Average Assets = [(Total Assets at the beginning of period + Total Assets at the end of period)] divided by 2
9. Return on Invested Capital (ROIC):
Return on Invested Capital (ROIC) ratio gives more insights than ROE ratio, as the computation of this ratio includes all sources of capital including both – equity and debt. It is one of the most important valuation ratios. ROIC is compared with the total cost of capital; ROIC should be higher than the cost of capital, if ROIC is consistently below of cost of capital then the business is not sustainable. ROIC is used most widely for those industries which uses huge capital. Company is considered value creator if ROIC is higher than the cost of capital.
Formula to calculate ROIC:
Return on Invested Capital (ROIC) (%) = [(NOPAT X 100) divided by Invested Capital] %
Formula to calculate Invested Capital:
Invested Capital = Total Fixed Assets + Current Assets – Current Liabilities – Cash
Formula to calculate NOPAT (Net Operating Profit After Tax):
NOPAT = EBIT(1-Tax Rate %), here EBIT is Earnings before interest and taxes.
10. Return on Capital Employed (ROCE):
ROCE is also one of the important profitability ratios which is used for company valuation. Readers should never confuse with ROCE and ROIC, as both are different ratios.
Formula to calculate ROCE:
ROCE (%) = [(EBIT X 100) divided by Capital Employed] %
Formula to calculate Capital Employed:
Capital Employed = Total Assets – Current Liabilities
Q. What are profitability ratios? Ans. Profitability ratios show how profitable a company and its business at different levels of profitability. Profitability Ratios are used to learn about the financial health of companies and their businesses. Investors, lenders, creditors and analysts use the profitability ratios to assess a company.
Q. What indicator best characterizes a company’s profitability? Ans. Profitability ratios such as – Return on Equity (ROE), ROIC (Return on Invested Capital), GPM (Gross Profit Margin), NPM (Net Profit Margin), etc. are used to measure a company’s profitability at different profitability levels.
Q. What are the different types of profit? Ans. Gross Profit, EBITDA, Operating Profit, PBT (Profit Before Tax) and PAT (Profit After Tax).
