Profitability ratios indicate the profit related performance of a company where it considers gross profit, net profit, operating profit etc. to calculate the profitability ratios.
The profit margin denotes the percentage of profit generated for each amount of sales volume. It means how much the company is earning in cash from each sales volume and shows the operating performance of the company in terms of generating cash.
Gross Profit Margin calculates the gross profit generated for each volume of sales. It shows the credibility of the company to generate high profit with less spending of raw materials and other goods.
Gross Profit Margin = (Gross Profit / Sales Revenue)
Operating profit is calculated from the gross profit after deducting the normal operational expenses like sales and marketing, administrative, office expenses etc. The operating profit margin shows how efficiently the company is running the business and offices. Higher operating profit margin indicates higher efficiency in running the business, sales and marketing related activities. EBIT (Earnings before Interest and taxes) is calculated from operating profit after adding the non-operating income.
Operating Profit Margin = (Operating Profit / Sales Revenue)
EBIT Margin = (EBIT / Sales Volume)
Net Profit is calculated from the operating profit after deducting the interest and taxes paid by the company. Net profit actually refers to the ultimate cash generated by the company over a period of time after deducting all the expenses.
Before tax payment the profit is called as EBT (Earnings before Tax) and after tax payment it is called as EAT (Earnings after Tax). Net profit is also known as Earnings after Tax (EAT) or Net Income as well.
Net Profit Margin = Net profit (EAT) / Sales Volume
EBT Margin = Earnings before Tax (EBT) / Sales Volume
The Profitability ratios are not only calculated based on the sales volume, they are also calculated based on the total asset, total equity or total capital employed.
The company may be having huge asset or equity capital but generating very less sales revenue because of lower efficiency and bad sales and marketing spending. In this case, the profit margins can be high because of lower sales and marketing spending and ignoring other important spending. In this case the profit margins do not actually show the profitability or performance of the company, all the other profitability ratios calculated based on assets and equity should also be considered here. These ratios check the profitability of the company related to its total assets and equity.
The Return on Asset ratio shows how the company’s management is using its total asset to generate profit. Higher return on asset means the company’s assets are properly utilized to generate higher profit.
Return on Asset = Net Income / Average Total Asset
Here the average total asset is used to consider any significant changes in total asset over a period of time, for which duration the net income is also considered. Suppose the company has generated 100 USD revenue for one particular quarter, while the asset was 400 USD and 600 USD at the beginning and end of the quarter respectively. Here the average asset of 500 USD will be considered to calculate the return on asset.
The total asset includes the cash and assets which were funded by the loans from the external creditors or debt raised from the market. For the loans and debts the company pays the interest every quarter. So when the assets actually include all these loans and debts the net income does not include the interests spend on them. The net income is only attributable to the shareholders. That’s another important profitability ratio Return on Equity (ROE) is used which considers only the average shareholders’ equity to check the profitability.
This is most widely used profitability ratio in the financial sector. Higher return on equity means the higher efficiency in utilizing its total equity capital to earn higher return for the investors.
Return on Equity (ROE) = Net Income / Average Shareholders’ Equity
If we break the same into different ratios we get
Return on Equity (ROE) = (Net Income / Sales Revenue) *
(Sales Revenue / Average Total Asset) *
(Average Total Asset / Average Shareholders’ Equity)
= Net Profit Margin * Asset Turnover * Leverage Ratio
Another important profitability ratio Return on Capital Employed (ROCE) is also used to include the debt and liabilities of the company. Here the term capital employed refers to the sum of all the debt liabilities and shareholder’s equity, which means all the cash employed by the management to conduct the business.
It is widely used to check the management’s capability to use debt and equity source of income properly to generate profit. Too much debt liabilities are bad for solvency of the company and too less debt means the company is not utilizing the cheap source of money. This ratio considers the management’s ability to raise capital properly to run the business and generate profit.
Return on Capital Employed = Net Income / (Total Capital Employed)
Where: Total Capital Employed = Average Liabilities +
Average Shareholders’ Equity
All these profitability ratios are used depending on the need to analyze the profitability of the company and efficiency of the company’s management.