Profitability Ratio: Formula, Types and Limitations

Profitability ratios are useful tools that help people understand how well a business is making money. These numbers show how much profit a company earns from its sales, assets, or investments, offering insight into how efficiently the business is run. Whether you're an investor, analyst, or business owner, knowing these ratios can help you make smarter financial choices.

What Is Profitability Ratio?

A profitability ratio is a financial measure that shows how much profit a company makes compared to another key figure like sales, assets, or equity. These ratios help assess the company’s ability to generate income and control its costs effectively.

For instance, if a business has high sales but low profit, it might be spending too much on operations. Profitability ratios help identify such concerns early on.

Types of Profitability Ratios

Profitability ratios can be grouped into two broad types:

1. Margin Ratios

These ratios measure how much profit a company earns from its sales. They reflect cost efficiency and pricing strength.

• Gross Profit Margin

• Operating Profit Margin

• Net Profit Margin

2. Return Ratios

These show how well a company uses its assets or capital to generate profit. They’re often used by investors.

• Return on Assets (ROA)

• Return on Equity (ROE)

• Return on Capital Employed (ROCE)

Each ratio highlights a specific aspect of profitability and helps provide a clearer view of business performance.

Formula and Calculation of Profitability Ratios

Let’s explore the common formulas:

• Gross Profit Margin = (Gross Profit / Revenue) × 100
  Gross profit is revenue minus the cost of goods sold (COGS), which includes materials and labour.

• Operating Profit Margin = (Operating Profit / Revenue) × 100
  This margin shows the profit from regular business operations, before taxes and interest.

• Net Profit Margin = (Net Profit / Revenue) × 100
  Net profit margin tells us how much of the revenue remains as profit after all expenses.

• Return on Assets (ROA) = (Net Profit / Total Assets) × 100
  ROA reveals how efficiently the company uses its assets to generate earnings.

• Return on Equity (ROE) = (Net Profit / Shareholder’s Equity) × 100
  ROE shows the return generated on funds invested by shareholders.

• Return on Capital Employed (ROCE) = (EBIT / Capital Employed) × 100
  ROCE highlights the efficiency of using both debt and equity capital in generating profits.

Importance of Profitability Ratios

Profitability ratios are essential because they:

• Show financial health: They highlight how well a company turns its revenue into profit.

• Guide investments: Investors use them to compare companies and find strong performers.

• Support lending decisions: Banks rely on these figures to assess a borrower’s ability to repay.

• Assist in strategy: Business leaders monitor these ratios to adjust plans and control costs.

They are a clear window into how a business is performing, especially when reviewed over time.

Commonly Used Profitability Ratios

• Gross Profit Margin

This margin shows how much profit is left after paying for direct costs like materials and labour.

Example:

Revenue = ₹20 lakh, COGS = ₹12 lakh, Gross Profit = ₹8 lakh
Gross Profit Margin = (8 / 20) × 100 = 40%

• Operating Profit Margin

It measures how well the company controls its operating costs.

Example:

Operating Profit = ₹5 lakh, Revenue = ₹20 lakh
Operating Profit Margin = (5 / 20) × 100 = 25%

• Net Profit Margin

This margin reflects the bottom-line earnings after all expenses.

Example:

Net Profit = ₹3 lakh, Revenue = ₹20 lakh
Net Profit Margin = (3 / 20) × 100 = 15%

• Return on Assets and Equity

These ratios show how effectively the business uses its resources.

Example:

Net Profit = ₹10 lakh, Total Assets = ₹50 lakh
ROA = (10 / 50) × 100 = 20%

If the Shareholder’s Equity is ₹40 lakh, then
ROE = (10 / 40) × 100 = 25%

Profitability Ratios vs Liquidity Ratios

Profitability and liquidity ratios measure different aspects of a company’s health.

Both sets of ratios are important for building a complete financial picture.

Limitations of Profitability Ratios

While these ratios are valuable, they have certain drawbacks:

• Different accounting methods: Companies may record revenue and expenses differently.

• One-time gains or losses: These can distort the results for a single year.

• Lack of cash flow data: A company might show profit but still struggle with cash.

• Industry-specific norms: Good ratios in one sector might be below average in another.

Because of these issues, it’s best to use profitability ratios with other metrics and industry benchmarks.

Conclusion

Profitability ratios help you understand how well a company turns its revenue, assets, or equity into profit. They’re widely used by investors, lenders, and business managers to make important financial decisions. While no ratio tells the full story, these figures offer a clear starting point for analysis.

To get the most value, compare the ratios over several years and with similar companies in the same industry. When combined with other financial indicators like liquidity, efficiency, and solvency ratios, profitability ratios provide a strong base for making informed choices.