Before investing, it is important to evaluate the ability of the company and how the company generates income as compared to its expenditure and other cost associated with income generation during a specified period. The profitability ratio of the company plays a major role in evaluating the income-generating abilities of the company. In this Blog, we will pen down what is Profitability Ratio and its Types.
Profitability ratios are values ??that are used to rank the probability that an investment will be a profitable business for an investor. These ratios are determined using a calculation that compares the capital requested for the investment with the present value of the investment. For stockholders, the profitability ratio is an estimate of the likelihood that a company will generate profits in the future. The profitability ratio is used to estimate whether a shareholder can expect to see a return on a stock investment.
Profitability ratios help companies maximize efficiency and discover new ways to improve their finances. Regardless of the position within a company, considering how profitability ratios benefit your business can help in improving your professionalism. By taking the time to learn more about net profitability ratios and how to use them effectively, you can help your company identify areas for financial growth.
Importance of Profitability Ratio
Profitability ratios is important as they allow stakeholders to overview the performance of the company with some precision. The analysis of Profitability ratio information can be of special value in certain circumstances:
- Helps in attracting investors: Generally, Investors want to see that a company has the capacity to be profitable before they make any investments. Profitability ratios provide the data investors need to make sound investment decisions.
- Evaluating seasonal businesses: Companies whose net sales revenue varies greatly from one season to the next can benefit from using profitability ratios. By comparing the past performance and the company's earnings across the same quarter over past years, management has a clear measure of profitability that helps them make proper budgeting and strategic planning decisions.
- Disclosing complex areas of a company: Financial statements, including balance sheets and income statements, can only reveal the big picture about a business. Assessments that include profitability ratios allow analysts to investigate various areas of the business to spot specific problems, such as a rising cost of goods sold.
- Analysis of Peers: If Peers are more established than a small business, a comparison of revenue may not be revelatory or helpful. However, a comparison of profitability ratios lets small business owners know how they measure up in terms of efficiency and profit, which is helpful.
Types of Profitability Ratios
The most useful types of profitability ratios can be categorized in three ways:
Margin ratios: Margin ratios is the type of Profitability Ratio that give insight, from various different angles, on a company's ability to turn total sales into profits.
Return ratios: Return ratios is the type of Profitability ratio which are calculated using data from a profit and loss statement and balance sheet, of a company which provide information about how effectively the business generates returns. The Return ratio helps in measuring how well the company converts assets, equity, and debt into return on investment.
Cash flow ratios: Cash flow ratios move beyond the bottom line to help businesses understand whether they're running a cash surplus or deficit. They're particularly important because a lack of cash can cause even a profitable business to fail.
Key Ratios of Margin Profitability Ratios
Among the key margin ratios that provide useful data are-
Gross profit margin ratio: Measure a company's net income after subtracting the cost of goods sold (COGS).
Gross Profit Margin = (Revenue Cost of Goods Sold) / Revenue*100%
Net profit margin ratio: Measure income and earnings after all expenses and taxes have been deducted.
Net Profit Margin= PAT / Revenue * 100%
Operating profit margin: Measures sales income after subtracting operating expenses and COGS.
Pretax margin: Measures company profits after subtracting operating costs, non-operating expenses, and COGS.
EBITDA margin: Measures earnings before interest, income tax and other taxes, depreciation, and amortization (EBITDA); some companies also measure EBIT (earnings before interest and tax).
EBITDA = PAT + Interest + Taxes + Depreciation and Amortization EBITDA Margin = EBITDA / Revenue * 100%
Key Ratios of Return Ratios
Return on equity (ROE): This shows how well a company uses investments to generate profits. Calculated as net profits divided by investors' or shareholders' equity, this equity ratio helps to evaluate the efficacy of a company's financial management.
Return on assets (ROA): This shows how well a company uses its total assets to generate profits and can be increased through economies of scale. This Asset Ratio is particularly useful for companies in sectors that require significant investment in assets, such as the telecommunications or manufacturing sectors.
Return on capital employed (ROCE): Indicates how well a company uses its capital resources, including retained earnings, share capital, and long-term debt.
Key Ratios of Cash Flow Profitability Ratios
Cash flow margin ratio: Measures cash movement across a given period by adding changes in working capital and non-cash entries back into the company's net profits.
Net cash flow ratio: Measures whether a company is running a cash surplus or deficit to determine whether it needs additional financing.
In a nutshell, we can say Potential, existing Investors, and creditors can use profitability ratios to analyze the company's investment on investment based on its relative level of resources and assets. We can also say profitability ratios can be used to judge whether companies are making enough operational profit from their assets.