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Profitability ratios may be easy for a finance professional at a large corporation to understand, but they can be trickier for those setting out on a new business venture to get their head around. In fact, these calculations are relatively easy to work out. Plus, they’re worth knowing, since they can offer important information that can be used to grow a business.
In this post, we’ll discuss what a profitability ratio is and provide an explanation of some of the most widely used calculations. We’ll also look at the limitations of profitability ratios.
Definition of profitability ratios
Profitability ratios are financial metrics used to measure and evaluate business performance in terms of income (profit), whether relative to revenue, assets, operating costs or shareholder equity, over a given period of time.
Each different definition of profit is a profitability KPI in itself, and can be used as a way to measure business performance.
What are good profitability ratios?
Higher profitability ratios are, as you would expect, preferable, but they need to be compared to the ratios of competitors, past performance, and industry averages. If a company has a higher profitability ratio compared to a competitor, or relative to the same ratio from a previous period of time, this indicates a company is doing well.
Types of profitability ratios
Profitability ratios fall into two general categories: margin ratios and return ratios. Margin ratios offer insights on a business’s ability to turn sales into profit. Return ratios offer ways to examine how successfully a company is generating returns for its shareholders.
Types of margin ratios
Gross margin measures how much a business is making after accounting for COGS (costs of goods sold).
Operating margins are the percentages of sales left after accounting for COGS and operating margins.
The net profit margin is a business’s ability to generate earnings when all expenses and taxes have been taken into consideration.
Types of return ratios
Return on assets (ROA): This profitability KPI measures profitability relative to costs and expenses in terms of assets. It can be used to identify how well a company is using these to generate sales and profits. The more assets amassed, the more sales and potential profits a company can make. Economies of scale can help to decrease costs and boost margins.
Return on equity (ROE): This key profitability KPI measures how well a company is doing in terms of earning a return on its equity investments. It’s calculated as net income divided by shareholder equity and illustrates the percentage of earnings an investor gets in return for the money they invest in the company.
Return on capital employed (ROCE): This profitability ratio measures how effectively a company is using its capital to generate profits and it’s often used as a KPI to determine whether a company is worth investing in or not.
Limitations of profitability ratios
Values of investments and profits can be manipulated to raise or lower profitability ratios, which can be misleading for investors and stakeholders.
Errors behind the various value calculations on a financial statement can lead to miscalculated ratios, which could pose risk to investors, and to the business going forward.
Ratios can be high due to chance, and therefore can’t be seen as 100% reliable. The context behind profitability KPIs must always be checked to confirm the analysis.
Profitability ratios provide an important way for companies to measure their success and are pivotal in the investment journey of a business. They can show whether a company is doing better or worse than it has done historically, and provide a comparison of how a business is performing compared to a competitor or against industry benchmarks.
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