Profitability Ratios Formula (Table of Contents)
Profitability Ratios Formula
Profitability, as its name suggests, is a measure of profit which business is generating. So Profitability ratios are basically a financial tool which helps us to measure the ability of a business to create earnings, given the level of expenses they are incurring. These ratios take into account various elements of the Income statement and balance sheet to analyze how the business has performed. Higher the value of these ratios as compared to competition and market, better the business’s performance.
There are various types of Profitability ratios. Let see all those ratios one by one :
- Profit Margin Ratios: These ratios compare various profits of the business (gross profit, operating profit, net profit, etc.) with its sales.
Gross Profit = Sales – COGS
Operating Profit = Earnings Before Interest & Tax (EBIT) = Sales – COGS – Operating Expenses
- Return on Assets: This ratio basically tells us that what is the return which business is generating giving the level of assets the business has.
- Return on Equity: This ratio measure level of return which business is producing for each dollar which an investor has put into it. So basically, it compares the income with the equity which investors have invested.
Examples of Profitability Ratios Formula (With Excel Template)
Let’s take an example to understand the calculation of Profitability Ratios formula in a better manner.
Profitability Ratios Formula – Example #1
A Company ABC Inc. has following items on its balance sheet. Calculate the profitability ratio formula for the same.
Now let’s calculate Profitability Ratios using formula.
1. Gross Profit Margin:
Gross Profit Margin is calculated using the formula given below
Gross Profit Margin = (Gross Profit / Sales) * 100
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- Gross Profit Margin = ($400 / $1000) * 100
- Gross Profit Margin = 40%
2. Operating Profit Margin:
Operating Profit Margin is calculated using the formula given below
Operating Profit Margin = (Operating Profit / Sales) * 100
- Operating Profit Margin = ($200 / $1000) * 100
- Operating Profit Margin = 20%
3. Net Profit Margin:
Net Profit Margin is calculated using the formula given below
Net Profit Margin = (Net Income / Sales)* 100
- Net Profit Margin = ($140 / $1000) * 100
- Net Profit Margin= 14%
4. Return on Assets
Return on Assets is calculated using the formula given below
Return on Assets = (Net income / Assets)* 100
- Return on Assets = ($140 / $1000) * 100
- Return on Assets = 14%
5. Return on Equity:
Return on Equity is calculated using the formula given below
Return on Equity = Net Income / Shareholder’s Equity
- Return on Equity = $140 / $700
- Return on Equity = 20%
Profitability Ratios Formula – Example #2
Let us look at this industry example to understand Profitability Ratios formula better. I have taken Tata Motors as an example :
Income Statement:
Balance Sheet:
Stockholder’s Equity:
Source Link: https://in.finance.yahoo.com/quote/TTM/financials?p=TTM
With the help of the balance sheet and Income statement, we have the following information for the year 2018:
Now let’s calculate Profitability Ratios using formula.
1. Gross Profit Margin:
Gross Profit Margin is calculated using the formula given below
Gross Profit Margin = (Gross Profit / Sales) * 100
- Gross Profit Margin = ($1,259,786,700 / $2,942,425,700) * 100
- Gross Profit Margin = 42.81%
2. Operating Profit Margin:
Operating Profit Margin is calculated using the formula given below
Operating Profit Margin = (Operating Profit / Sales) * 100
- Operating Profit Margin = ($117,875,100 / $2,942,425,700) * 100
- Operating Profit Margin = 4.01%
3. Net Profit Margin:
Net Profit Margin is calculated using the formula given below
Net Profit Margin = (Net Income / Sales)* 100
- Net Profit Margin = ($90,913,600 / $2,942,425,700) * 100
- Net Profit Margin = 3.09%
4. Return on Assets
Return on Assets is calculated using the formula given below
Return on Assets = (Net income / Assets)* 100
- Return on Assets = ($90,913,600 / $3,313,505,100) * 100
- Return on Assets = 2.74%
5. Return on Equity:
Return on Equity is calculated using the formula given below
Return on Equity = Net Income / Shareholder’s Equity
- Return on Equity = $90,913,600 / $954,279,100
- Return on Equity = 9.53%
Things to Remember
- We cannot rely only on gross profit margins and it will not tell us the true story. Since gross margin does not include the operating expenses, sometimes this can be misleading. For example, Business may have good gross margins but due to high operating expenses, the net profit margin is not that good.
- Although profitability ratios formula helps us to analyze business performance, these ratios are universally comparable. Companies operating in different industries have a different way of operating and different expenses. For example, a Net profit margin of IBM cannot be compared with Starbucks.
- Similarly, a decrease in net profit margin is not always bad for a business which is at a growing stage. Sometimes, business forgoes their profits and margin and give huge discounts to customers to increase their presence in the industry and customers.
- Business can artificially inflate the return on asset number by reducing their assets on the balance sheet. One way of doing this is by choosing a different depreciation method compared to the competition. For example, If company A is using a straight-line method for depreciation and B is using double declining method, B will have higher ROA in the beginning and lower at the end compared to A
- Sometimes, companies have seasonal sales and income can vary accordingly. So it is always advisable to compare profitability ratios of a company with its performance compared to the same period last year
Relevance and Uses Profitability Ratios Formula
Profitability ratios formula is one of the key tool for financial analysis. Everyone wants to grow their hard earned money and will not like to invest in businesses which are not sound. Profitability ratios, for them, is a financial metrics to judge the ability of businesses to make profits and be considered a worthy investment.
Investors, portfolio managers and even people who are not well versed with financial knowledge can use this tool to make an informed decision about the performance of the companies where they want to invest. On the same line, management of the company can also make business-related decisions like expansion, diversification, etc. so that they can improve their profitability.
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