Profitability Ratios: Meaning, Formula, Benefits, Limitations and More

Suppose a business makes ₹10 Lakh in revenue during the financial year. At first, it might look very impressive. But if I tell you the business spent ₹9.50 lakh to make this revenue. Suddenly, the picture looks very different.

This is where the profitability ratio comes into the picture. Profitability ratios help assess whether a business has generated sufficient profit from its sales, assets, and investments. Instead of looking at how much profit a company makes, the profitability ratio helps you gauge how efficiently the business has earned that profit.

Profitability ratios are one of the most valuable financial tools for business owners, investors, managers, and other market participants. Profitability ratios help to compare different companies and evaluate their strengths and weaknesses. They also help assess the financial health of a company.

To put simply, profitability ratios represent the company's efficiency in generating profit in relation to its sales, assets, equity, or other financial resources.

What is a Profitability Ratio?

The profitability ratio is a financial ratio that measures a company's ability to generate profits.

A company can have high sales but low profit margins due to higher expenses. It is also possible for a business to have lower sales but earn high profits because it manages its costs efficiently.

Let us understand this with a simple example where Company A and Company B both have sales of ₹10 lakh.

• Company A makes a profit of ₹1 lakh.
• Company B makes a profit of ₹2 lakh.

Even though Company A and Company B have the same sales level, Company B is more profitable. Profitability ratios help us see this distinction.

Importance of Profitability Ratios

It is essential to analyse profitability ratios since profit is among the primary objectives of every organisation. An enterprise should generate enough profit to sustain its operations, expand, repay loans, pay dividends to the shareholders, and make investments. Here are some of the main reasons why profitability ratios are critical.

Assess the Business Performance

Profitability ratios reveal whether the financial performance of a company is improving or deteriorating.

For instance, when the net profit margin of a company rises from 8% to 12%, it indicates that the business has become more efficient or has reduced its expenses.

Helpful for Investors in Decision-Making

Investors need to understand whether a company is capable of earning sufficient returns from the funds invested in it. Profitability ratios provide this information and help investors evaluate a company's profitability.

Useful for Management to Control Expenses

In case of declining profitability, the management can analyse expenses and identify areas where money is wasted.

Helps in Business Comparisons

A large company will have higher overall profits than a smaller company. Thus, comparing total profits will be unfair. With profitability ratios, it becomes possible to compare companies of different sizes.

Reveals Financial Strength

Consistent profitability often indicates that a company has a solid business model. However, profitability must be analysed alongside liquidity, debts, cash flow and other financial ratios.

Types of Profitability Ratios

There are various profitability ratios; however, some of the most commonly used profitability ratios are:

• Gross Profit Ratio
• Operating Profit Ratio
• Net Profit Ratio
• Return on Assets
• Return on Equity
• Return on Capital Employed

Let us try to understand each of them through examples.

Gross Profit Ratios

The gross profit ratio assesses the relation between the gross profit and net sales. Gross profit is the difference between sales and the cost of goods sold.

Gross Profit Formula Gross Profit Ratio = (Gross Profit ÷ Net Sales) × 100

Suppose there is a clothing company that has the following figures:

• Net Sales = ₹10,00,000
• Cost of Goods Sold = ₹6,00,000
• Gross Profit = ₹10,00,000 − ₹6,00,000 = ₹4,00,000

Thus,

Gross Profit Ratio = (₹4,00,000 ÷ ₹10,00,000) × 100 = 40%

In other words, the gross profit earned by the company is ₹40 for every ₹100 of sales.

A high gross profit ratio indicates effective control over production or purchase costs by the company. An increasing ratio suggests an increase in costs, a decrease in selling prices, or increased competition. A decreasing ratio may suggest an increase in costs, a decrease in selling prices, or increased competition.

Operating Profit Ratio

The operating profit ratio represents the profits generated by the company through its core activities.

Operating profit focuses on the company’s operating activities and ignores non-operating activities.

Operating Profit Formula

Operating Profit Ratio = (Operating Profit ÷ Net Sales) × 100

Assuming that a company has:

• Net Sales = ₹20,00,000
• Operating Profit = ₹4,00,000

Operating Profit Ratio: = (₹4,00,000 ÷ ₹20,00,000) × 100 = 20%

It implies that the company generates an operating profit of ₹20 for every ₹100 of sales. It is very helpful for the management as it provides insight into the efficiency of the company’s core business. When sales are growing, but operating profit is decreasing, the company needs to investigate factors such as increasing salaries, rent, marketing costs, production costs, and other operating expenses.

Net Profit Ratio

The net profit ratio is one of the most common profitability ratios. This ratio measures the net profit made by the organisation after accounting for related expenses.

• Net Profit Formula
• Net Profit Ratio = (Net Profit ÷ Net Sales) × 100

Assuming that a business has the following:

• Net Sales = ₹50,00,000
• Net Profit = ₹5,00,000

Net Profit Ratio = (₹5,00,000 ÷ ₹50,00,000) × 100 = 10%

This indicates that the organisation earns a net profit of ₹10 for every ₹100 of sales.

In another scenario, let's say two restaurants earn ₹50 lakh in sales per year.

They make the following net profit:

• Restaurant A makes ₹4 lakh
• Restaurant B makes ₹8 lakh

Their net profit ratios would be:

• Restaurant A = 8%
• Restaurant B = 16%

Even though they have similar sales, Restaurant B earns double the amount of profit from every ₹100 of sales.

Return on Assets (ROA)

Return on Assets (ROA) is a ratio that shows how well the company utilises its assets to earn profit. A company invests its assets, which include buildings, machinery, vehicles, equipment, inventories, and cash, to carry out its operations.

ROA Formula

ROA = (Net Profit ÷ Average Total Assets) × 100

Let us assume that a company has made a net profit of ₹6 lakhs and its average total assets are ₹60 lakhs.

ROA = (₹6 lakh ÷ ₹60 lakh) × 100 = 10%

This means that the company makes a profit of ₹10 on each ₹100 investment in its assets.

ROA is especially helpful when comparing companies in the same industry. For instance, if there are two manufacturing companies with similar asset levels but different ROAs, the latter firm is more efficient in utilising its assets. It should be noted that ROA can be calculated based on the beginning assets, ending assets, or average assets.

Return on Equity (ROE)

Return on Equity (ROE) is an indicator that reflects the return earned on the shareholders' equity. Simply put, it helps the shareholders know how well the company is performing with respect to their investments.

ROE Formula

ROE = (Net Profit ÷ Average Shareholders' Equity) × 100

Assuming:

• Net Profit = ₹10 lakh
• Average Shareholders' Equity = ₹50 lakh

ROE = (₹10 lakh ÷ ₹50 lakh) × 100 = 20%

It indicates that for every ₹100 of the shareholders' equity, the company earned ₹20 in profits. ROE is an important indicator for investors. However, a very high ROE does not necessarily mean that a business is performing exceptionally well. Heavy borrowing may reduce the equity relative to the business’s assets, thereby making ROE very high.

Return on Capital Employed (ROCE)

Return on Capital Employed (ROCE) indicates how effectively the company utilises the capital available to generate operating profits. It is especially helpful in analysing companies that require substantial capital investment, such as those in manufacturing, infrastructural projects, and utilities.

ROCE Formula

ROCE = (EBIT ÷ Capital Employed) × 100

In which EBIT stands for Earnings Before Interest and Tax.

Assuming:

• EBIT = ₹15 lakh
• Capital Employed = ₹75 lakh

ROCE = (₹15 lakh ÷ ₹75 lakh) × 100 = 20%

This implies that the company earns a 20% ROCE from the capital employed. There may be slight differences in how different analysts define capital employed.

Benefits of Profitability Ratios

• Simplify Financial Information: Profitability ratios simplify complex financial data into an easily understandable form. Instead of analysing hundreds of financial data points, one can use key ratios to understand the company’s performance.
• Identify Trends: Profitability ratios help determine the profitability trends of a company. For instance, if the net profit ratio of a company has been declining consistently over three years, it could indicate that something is wrong with the business.
• Make Comparisons Easier: Profitability ratios facilitate comparisons of the performance of different companies, regardless of their size. This assists investors and managers in determining which company performs well.
• Support Decision-Making: Profitability ratios are useful in decision-making. They help investors analyse investment opportunities while helping managers identify areas of business operations that need improvement.

Also Read: Ratio Analysis: Meaning, Types of Ratios with Formulae

Limitations of Profitability Ratios

Although profitability ratios are beneficial, they have some limitations.

• They rely on accounting data: The accounting technique that a firm uses affects its profit and asset amounts. Therefore, two firms may have different numbers even though their businesses are similar.
• They are not comprehensive: A firm can experience cash flow problems despite being profitable. Therefore, profitability ratios should not be used alone.
• Differences between industries: A good ratio in one industry may be average in another.
• Historical data do not predict future results: While past profitability can give useful information, it does not mean that the firm will be successful in the future.
• Debt can influence returns: For a company with a high level of debt, the ROE can be high because of its relatively low shareholders' equity.

FAQs

What is a profitability ratio?

A profitability ratio measures a company's ability to generate profit from its sales, assets, or capital.

Why are profitability ratios important?

They help investors, managers, and business owners evaluate a business’s financial performance and earning capacity.

What are the main types of profitability ratios?

Common types include Gross Profit Ratio, Operating Profit Ratio, Net Profit Ratio, ROA, ROE, and ROCE.

What is Gross Profit Ratio?

It measures the percentage of sales remaining after deducting the cost of goods sold.

What is Net Profit Ratio?

It shows the percentage of sales that remains as net profit after considering the relevant business expenses.

What is the difference between profitability and liquidity ratios?

Profitability ratios measure the ability to earn profit, while liquidity ratios measure the ability to pay short-term obligations.

Is a higher profitability ratio always better?

Generally, a higher ratio is positive, but it should be compared with industry standards and the company's past performance.

Can profitability ratios help investors?

Yes. Investors can use profitability ratios to assess how efficiently a company generates profits and uses its resources.