The ability to generate profit is one of the important parameters to gauge the health of a company. Profitability reflects a company’s competitive position in the market and the quality of its management. The profitability of a company can be ascertained by looking at the company’s income statement. The income statement reveals the source of earning and components of revenue and expenses. Earnings can be distributed to shareholders or reinvested in the company.
Calculation of profitability ratios
The profitability ratio measures the return earned by a company during a given period. There are two subsets in profitability ratios:
- Return on sales profitability ratio: This ratio reflects various sub-totals like gross profit, operating profit, net profit as a percentage of revenue.
- Return on investments: This ratio reflects the income generated against the company’s assets, equity or total capital employed.
Formula and explanations:
- Gross Profit Margin: It indicates the percentage of revenue available to cover operating and other expenses to generate profits. Higher the ratio, higher is the product price and lower the product cost. It indicates that the company has a competitive edge in product cost. Gross margin is usually inversely related to competition. It is calculated by dividing gross profit by revenue.
- Operating Profit Margin: It is also known as EBIT (earnings before interest and taxes). If operating margin increases faster than gross profit margin, it means there is an effective control on the overhead cost. It is calculated by dividing EBIT by revenue.
- Net Profit Margin: It gives a better view of the company’s future profitability. It is calculated by deducting all expenses from the revenue. It is calculated by dividing net profit by revenue.
- ROA (Return on Assets): It indicates how profitable the company is relative to its assets. Also, it gives an idea about how efficiently the company is using its assets to generate returns. It is calculated by dividing net income by total assets.
- ROCE (Return on Capital Employed): It is a financial ratio that measures a company's profitability and the efficiency with which its capital is employed. It is calculated by dividing net income by total capital employed.
- ROE (Return on Equity): It measures a company’s profitability by revealing how much profit a company generates with the money shareholders have invested. It is calculated by dividing net income by shareholder’s equity.
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