Profitability ratios are financial metrics to gauge and assess the capacity of an organization to produce a profit in relation to its revenue, balance sheet assets, or stakeholder’s equity, operation costs during a definite period. This metric used by investors and market gurus can be compared with efficiency ratios, which judge the optimal utility of internal resources to generate profit.
What Does it Mean by a Higher Profitability Ratio?
A higher profitability ratio implies the organization is operating well, generating enough profit, cash flow and revenue, long-term investors like to invest in such well-managed companies. This metric gives a reasonable comparison of performance with peers or the preceding period.
Two Types of Profitability Ratios
All profitability ratios can be categorized into segments;
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Margin Ratios
This metric represents the firm’s capacity to transform sales into profit at various points in time. Examples of margin ratios are gross profit margin, net profit margin, cash flow margin, operating profit margin, EBIT (Earnings before interest and taxes), EBITDA (Earnings before interest and taxes, depreciation, amortization), operating expense ratio and overhead ratio.
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Return Ratios
This parameter states the organization’s ability to produce a return to the shareholders. Return on assets, return on equity, return on debt, return on revenue, cash return on assets, return on invested capital are examples of margin ratios.
What is the profitability ratio? Answer to it is a metric to analyze the productivity of the business by weighing against sales, assets, and equity.
Importance of Profitability Ratio
Profitability profit analysis states the final performance of the company, how profitable the venture is. Profitability analysis also represents how the stakeholder’s equity has been utilized by the organization.
There are different profitability ratio formulas used by entities to analyze the financial performance and stability of the business.
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Gross Profit Margin is the most used profitability ratio formulas stating the difference between revenue and cost of production, also known as cost of goods sold (COGS). Some sectors experience seasonality in their business operations. For instance, patisserie firms experience considerably higher revenue and profit earning during the Christmas holiday season. It would be more effective and informative to compare the fourth-quarter profit margin with the fourth quarter of last year than to the first quarter of the previous period.
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EBITDA (Earnings before interest, taxes depreciation, and amortization) states the profitability of a firm before deducting non-operation items such as interest and taxes and non-cash items like depreciation and amortization. The usefulness of this metric is to compare performance with peers since it excludes expenses that could be variable.
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Operating Profit Margin is one of the profitability ratios examples that represent profit as a percentage of sales before deducting interest and income tax. Companies with higher operating profit margins have an adequate reserve to pay interest and other fixed costs and have a better probability of surviving an economic meltdown. Due to higher profitability, they can offer products at a lower price than competitors.
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Net Profit Margin Means this metric represents the bottom line, the net profit after deducting interest and taxes. This profitability measure considers every aspect of accounts, but the disadvantage is it takes into account one-time gains and expenses, producing a lot of noise.
Useful Metrics in the Equity Market
Informative investors and corporate equity buyers also use these types of profitability ratios.
This profitability ratio represents the return on the invested equity and how it has been utilized to breed revenue of the company. Return on equity profitability ratio formula is profit after tax divided by net worth, where it stands for equity share capital and reserve and surplus.
This ratio is important from the standpoint of ordinary shareholders as it is calculated by net profit divided by the total number of shares outstanding.
This ratio exhibits the total amount of dividends distributed among stakeholders, which is derived by dividing the number of dividends distributed by the number of shares outstanding.
This metric is useful to determine if the stock value is overvalued or undervalued. This ratio also gives insight into expected earning and incentives to stakeholders. The formula of this ratio is the market price of a share divided by EPS (earning per share).
Hopefully, the article has covered all the significant information regarding profitability ratio in detail.