All business ventures and entrepreneurs aim for profit. Investors too aim to make profits in line with the growth in prices of the assets they invest in. But, how do you measure profit? How do you stay ahead of other companies and portfolios, and make a comparison? For instance, you calculate the absolute profit, the relative profit, and compare them against a company’s total revenue. The concept of profitability covers all of this. Let’s examine this concept closely in today’s article.
This article covers:
- What is profitability?
- Types of profitability ratios
- Merits of profitability
- Shortcomings of using profitability as a metric of success
What is profitability?
Profitability is a company’s ability to generate revenue over and above its expenses. It determines a company’s final performance and also states how profitable the company is and how the company’s funds have been utilised.
Profitability ratios help shareholders, stakeholders, and analysts to measure the company’s ability for revenue generation. This further helps to cover operational costs, create value, add assets to the balance sheet and analyse the company’s ability to expand and take on projects for future expansion and growth. Furthermore, profitability ratios are also used to compare the performance of companies against each other.
Usually, higher ratios indicate that a company is performing well. In addition to business owners, investment analysts also use profitability ratios to make wise investment decisions with regard to equity investments.
Types of profitability ratios
The various ratios and metrics help to compare past data and analyse a company’s strength to survive in a downtime. The various types of ratios are:
Gross profit margin
This is a ratio of gross profit to sales. The gross profit margin calculates the excess revenue a company over and above the cost of goods sold. Therefore, the formula can also be applied to measure the segment revenue. A high ratio determines a greater profit margin.
The formula to calculate gross profit margin is: (Gross profit ÷ sales) × 100
Where, Gross profit = Sales + Closing stock – Op stock – Purchases – Direct expenses
Net profit margin
It is a ratio of net profit to sales. Net profit is calculated after reducing the operational costs, depreciation, and dividend from gross profit. This ratio helps to measure a company’s overall profitability involving all direct and indirect costs.
A higher ratio or margin indicates that the company is earning enough not only to cover all its costs but also its payout to its shareholders or re-invest its profit for growth.
The formula to calculate net profit margin is: (Net profit ÷ sales) × 100
Where, Net profit = Gross profit + Indirect income – Indirect expenses
Operating profit margin
This represents the percentage of earnings to sales before interest expense and income taxes. Higher margins indicate that a company is eligible to pay its fixed and operational costs. A higher ratio is also a sign of efficient management and determines a company’s ability to survive in economic downtime compared to its competitors.
The formula to calculate operating profit margin is: Operating Profit = Sales – Expenses excluding interest and taxes
Return on equity
This ratio is commonly used in two situations. Firstly, it measures the profitability of equity funds invested in a company. Secondly, it measures how profitably the shareowner’s funds are utilised for the company’s revenue generation. A higher ratio indicates a better performing company.
The formula for return on equity is: Profit after tax ÷ Net worth
Where, Net worth = Equity share capital, and Reserve and Surplus
Return on assets
This formula calculates the earning per rupee of assets invested in a company.
The formula for return on assets is: Net profit ÷ Total assets
Earnings per share
This ratio helps to measure profitability from the perspective of an ordinary shareholder. A higher ratio indicates better performance.
The formula for earnings per share is: Net profit ÷ Total no. of shares outstanding
Dividend per share
This ratio takes into account the amount of dividends distributed by a company to its shareholders. If the ratio is high, it indicates that the company has surplus cash.
The formula for dividend per share is: Amount distributed to shareholders ÷ No of shares outstanding
Investors use this ratio to check a company’s undervalued and overvalued share price. This ratio further also determines the expectation about a company’s earning and payback period to its investors.
The formula for price-earnings ratio is: Market price of share ÷ Earnings per share
Return on Capital Employed
This ratio helps to measure a company’s percentage return on its invested funds.
The formula for calculating return on capital employed is: Net operating profit ÷ capital employed × 100
Where, Capital employed = Total assets – Current liability
EBITDA commonly measures a company’s performance with others. The formula is widely used in valuation and project financing. It represents earnings before interest, tax, depreciation, and amortisation.
The formula for EBITDA is: Sales – Expenses, excluding interest, tax, depreciation, and amortisation
Merits of profitability
Profitability helps to determine the pricing of products and services. For any business venture, pricing plays an important role as it not only increases net revenue but also helps to stay abreast of competitors’ pricing and thus helps in creating a pricing strategy.
Higher profitability is a direct sign of higher sales.
Profitability ratios help to analyse a company’s performance and liquidity derived from its income statements. It also determines a company’s strengths and weaknesses and how a company can achieve profit from its operations.
With profitability, you can also analyse investment returns from a business. In other words, you can measure how effectively the company is issuing its resources to generate value and profit. It also indicates if the company’s resources are properly deployed and if it can sustain itself in the future.
Shortcomings of using profitability as a metric of success
Profitability cannot predict the future performance of a company as companies are known to window dress their accounting statements.
Profitability cannot compare a company’s performance across different industries. For example, you cannot compare a pharmaceutical company with the FMCG industry.
While analysts use profitability ratios to determine a good proposal for investment choices, banking institutions use these ratio types to determine the creditworthiness of a company in order to sanction loans. Compared to other ratio types, profitability ratios are more important because all businesses ultimately tend to focus on earning profit and creating value for their stakeholders.