Profitability ratios are the investor guide to evaluate companies and make decisions. Here you will find all about profitability ratios, their types, and how to calculate them. You will also catch why they matter for your business growth and investment decisions.
What is Profitability Ratio?
Profitability ratios are a quick and easy way of helping you understand the financial health of your business. They allow you to compare the profitability of different companies and can help you know where you could be improving.
These analytical tools find a business’s potential and associated risks. It measures a company’s aptitude to make a profit relative to assets, equity, and other business metrics.
7 Types of Profitability Ratios
You can break financial ratios on return ratios and margin ratios groups. Now let’s find how they measure and evaluate a company’s financial performance.
Return on Equity – ROE
Do you want to find how well a company can manage your investment to make profits? ROE helps shareholders to measure the return on their investments and company management. You can calculate a company ROE with this formula.
% Return on Equity = Net Income / Average shareholder Equity * 100
A high % ROE indicates management has robust performance, while low ROE shows management doesn’t work well.
As an Investor, you would be concerned with the return on your investments with company other financial metrics. The shareholder equity and net income is available on the company balance sheet.
For investment prefer companies with ROE greater than 20% for the past three years.
Return on Assets – ROA
How does a company turn its investments into profits? ROA shows how efficiently a company converted its assets to improve the bottom line. The most common formula to calculate ROA is:
% Return on Assets = Net Income / Total Assets * 100
A high Return on Asset ratio means the company earns income efficiently by using the available assets. It also shows business asset intensity and how much profit after tax deductions the company generates for every asset rupee it holds.
Return on Capital Employed – ROCE
This profitability ratio shows the return in the company for investments made by owners. To calculate Return on Capital Employed uses the formula:
% Return on Capital Employed: Net Operating Profit / Capital Employed * 100
Capital employed means your total assets minus current liabilities. A high ratio indicates the company is performing well. Remember, only ROCE is not enough to make good investment decisions. With it, you will have to analyze other profitability ratios.
Operating Profit Margin – OPM
Company operating profit shows total revenue left after deducting operating expenses and cost of goods sold. The operating profit margin percentage shows percentage revenue after deducting all costs from net sales.
For calculation of the operating profit margin, use this formula. You will get calculation metrics from the company income statement.
% Operating Profit Margin = Operating Profit / Revenue (Net Sales) * 100
If you have a low operating profit margin with a good gross profit ratio, the company is spending more on operating costs. The operational costs need optimization.
Gross Profit Margin – GPM
Gross Profit Margin is among the first profitability ratio calculated by business owners. This ratio tells how much sales are left after deducting the cost of goods sold. And it indicates how much money is available to cover operational expenses, added depreciation, tax, and other business costs.
To Calculate Gross Profit Margin, you will need Gross Profit and Revenue (net sales). This figure is present in the business income statement. Use the simple formulae below to calculate your business Gross Profit Margin.
% Gross Profit Margin = Gross Profit / Net Sales (Revenue) * 100
Net Profit Margin – NPM
At the bottom line, how much does your company generate? The Net Profit Margin ratio shows a total profit after all expenses incurred. Calculate Net profit margin with this formula:
% Net Profit Margin = Net Income / Total Revenue* 100
You can get both figures from financial statements. A high net profit margin ratio means the business is running perfectly. And the company is efficiently managing goods & services sourcing and other costs.
Price to Earnings Ratio – PE
This ratio shows company earnings, investors, payback period, and undervalue & overvalue share prices. It is essential investment research, especially for profitable stock market investments. The simple formula to calculate it is:
% Price to Earnings ratio = Share Market Price / Earnings per share * 100
High PE indicates investors are willing to pay more for shares. Companies with a high Price to Earnings ratio are considered best for stock investments with optimistic futures.
Remember to compare a company’s PE ratio with others in the same industry for the best decision-making.
Why do Profitability Ratios matter?
Profitability ratios are important for both companies and investors to optimize performance and results. With it, you evaluate and understand the company’s real performance and profits.
By improving profitability ratios, you can become a benchmark for bank assessments and profitable investments.
Get new Investors
With healthy and performing profitability ratios, businesses can grab new investors easily. Normally investors rely on news and ratios to make investment decisions. If your financial business ratios indicate potential profits, you can attract new investors and grow well.
Make efficient investment decisions
As an investor, you want profits and long-term asset creation. The profitability ratios let you analyze and decide which small companies have an optimistic future. With proper financial metrics evaluation, you can make efficient investment decisions.
Compare your business with competitors
As a small business, you have competitors and well-established companies as a benchmark. Use profitability ratios to compare your profitability ratios with your competitors to determine how well your business measures up with them. Less income doesn’t only mean fewer profits. You can use the comparison to get new investments and grow efficiently.
Find business areas for potential improvement
Numbers alone never show the whole picture. Financial Profitability ratios uncover performance in separate areas to find potential improvement areas. E.g., a gradual decrease in gross profit margin can indicate a need to get the cost of goods sold under control.
How to improve your business profitability ratios?
Profitability ratios evaluate company performance and efficiency. Here for you, we have uncovered a few strategies to improve your financial metrics. It will assist in optimizing your profitability ratios and boosting performance:
Reduce Slow moving inventory and Unprofitable products
Evaluate to cut old inventory and slow-moving products. Now invest this money in other business areas and fast-moving inventory. Here the key is to optimize for high sales in fewer products and focus on services that generate the most profits.
Lower extra costs and expenses
Maybe your business gets lots of sales with high operating expenses that cut most of your profits. Here you have to work on lowering extra costs and expenses. You can negotiate or find new suppliers for goods. You can also perform a business evaluation to see where you are spending extra money that’s unnecessary.
Evaluate opportunities to increase the price
It can be tricky and sensitive to increase prices. Before rising prices, perform a competitor and analysis and find how loyal your customers are. Now start with a few test products or services.
Work to attract new customers
New customers bring more business to generate profits. You have to work on expanding your market and attracting new customers. The thing here is to keep old customers and grab new ones. After prices increment, market expansion works well to capture more customers.
To improve profitability ratios, work on reducing costs, increasing productivity, efficiency and turnover. You can start by preparing a checklist to begin optimizing your profitability ratios.
Can Profitability Ratios Mislead You?
Probability ratios are a matter for both businesses and investors. At the same time, these financial analyses can be misleading if you are not calculating them at regular intervals.
Think about the impact of Halloween and Christmas sales on profitability ratios. As a business owner, if you don’t have time, consider hiring a professional to calculate, analyze, and report financial ratios with you. As an investor, you should find how old were the financial ratios you analyzed.
Profitability ratios display company profitability and real performance. By analyzing all types of profitability ratios, you can make efficient investment decisions. As a business owner, you get lots of opportunities to optimize your business performance and get new customers & investors.
These financial ratios are important for both companies and investors to grow and make efficient decisions. Whether you own or invest in an asset, the perfume indicators tell all about its profitability. Analyze them collectively and ensure they are periodically updated, so they do not mislead you.
Now you are packed with all about the profitability ratios and why they matter to everyone. There is no “absolute” in finance. But by looking at each type of ratio, you will get a better picture of what’s happening. You can now understand how well an organization is doing?
Matthew is a Co-Founder at BusinessFinanceArticles.org. Matthew was a floor manager at a local restaurant in Wales. He lost his job after the pandemic and took initiative to make a team and start the project.