Types of profitability ratios
Now that you know about the profitability ratio’s meaning and its importance, let us move on to the types of profitability ratios:
Return on equity
Earnings per share
Dividend per share
Price-earnings ratio
Return on capital employed
Return on assets
Gross profit
Net profit
1. Return on equity
Return on equity measures a company’s ability to earn returns on its equity investments. A higher ROE means that a company can generate cash without relying heavily on debt. The formula for ROE is net income/shareholders equity.
2. Earnings per share
Earnings per share measures the profits earned by each common stock from a shareholder's point of view. It indicates a company’s profitability on a per-share basis. The formula for EPS is (net income - dividends on preferred stock)/weighted average of outstanding shares.
3. Dividend per share
Dividend per share measures the amount of dividends paid by a company to each of its outstanding shares of common stock. It helps investors to analyse a company’s stock based on its potential to provide returns as dividends. The formula for dividend per share is total dividends paid annually/total number of outstanding shares.
4. Price-earnings ratio
The price-earnings ratio allows investors to analyse a company stock based on its valuation. It measures the current share price relative to the company's earnings per share (EPS). Investors use the price-earnings ratio to understand whether the stock is undervalued or overvalued. The formula for the P/E ratio is market price per share/earnings per share.
5. Return on capital employed
Return on capital employed analyses the returns that funds invested by the owners have generated for the business. A higher ROCE indicates that the company has used the funds invested by the owners more efficiently, which may lead to a higher stock price. The formula for ROCE is earnings before interest and tax (EBIT)/capital employed. Here, capital employed is the difference between total assets and current liabilities or equity plus non-current liabilities.
6. Return on assets
Return on asset measures the amount of earnings made through the assets invested in the company. It helps investors understand how effectively the company is utilising its assets to generate income. If ROA is higher, it means that a company with a higher pool of assets has the potential to generate higher revenues. The formula for ROA is net income/total assets.
7. Gross profit ratio
The gross profit ratio, also known as gross profit margin, shows the revenue percentage generated by a company relative to its cost of goods sold. It measures a company's efficiency in producing and selling its products and earning higher revenue. A high gross profit ratio or margin implies that the company has the potential to manage production costs and earn better revenue. The formula for gross profit margin is (gross profit/sales) x 100. Here, gross profit is the difference between revenue and the cost of goods sold.
8. Net profit ratio
Net profit ratio, also known as net profit margin, measures the percentage of the amount that remains as net profit after all direct and indirect expenses. These expenses may include operating expenses, interest, taxes, and preferred stock dividends. Net profit margin allows investors to gauge the overall profitability and efficiency of a company in managing its total expenses relative to its revenue. The formula for net profit margin is (net profit/net sales) x 100. Here, net profit is operating profit - (direct cost plus indirect expenses), while net sales is sales minus returns.
Significance of Profitability Ratios
Profitability ratios are important financial tools that help you understand how efficiently a company generates profits from its operations. They show how well management uses resources such as revenue, assets, and equity to produce sustainable earnings. By analysing these ratios, you can gauge a company’s operational strength beyond just topline growth.
These ratios also help you compare companies within the same sector or track performance over time. Consistent or improving profitability ratios often reflect better cost control, pricing power, and business stability. This makes them useful for identifying financially strong businesses.
For investors, profitability ratios support informed decision-making. They help you assess long-term viability, shareholder value creation, and risk levels, especially when combined with other financial indicators and broader market analysis.
Limitations of Profitability Ratios
Profitability ratios are widely used to evaluate how efficiently a company generates profits. While they offer valuable insights, these ratios also come with certain limitations. You should always interpret them carefully and in combination with other financial metrics to avoid drawing incomplete or misleading conclusions.
Dependence on accounting policies: Profitability ratios rely on accounting figures, which can vary due to different accounting methods, depreciation practices, or inventory valuation techniques. This makes comparisons between companies less reliable.
Ignores cash flow position: These ratios focus on reported profits and do not reflect actual cash inflows or liquidity. A company may appear profitable but still face cash flow issues.
Historical in nature: Profitability ratios are based on past financial data. They may not accurately represent future performance or changing market conditions.
Impact of one-time items: Exceptional gains or losses can distort profitability ratios, giving a misleading picture of core business performance.
Industry-specific limitations: Comparing profitability ratios across different industries can be misleading due to varying cost structures and business models.
How Is Business Profitability Measured?
Business profitability is measured by analysing how efficiently a company generates profits from its operations, assets, and capital. It helps you understand whether a business can sustain itself, grow, and deliver value to its stakeholders over time.
One common way to measure profitability is through income-based metrics such as gross profit, operating profit, and net profit. These figures show how much income remains after accounting for costs, expenses, interest, and taxes, offering insights into operational efficiency.
Profitability is also assessed using financial ratios like gross margin, operating margin, net profit margin, return on assets, and return on equity. These ratios allow you to compare performance across companies or periods.
Additionally, cash flow analysis plays a role, as consistent operating cash flows indicate real, sustainable profitability beyond accounting profits.
Conclusion
Profitability ratios are financial metrics that are tremendously useful for investors to analyse a company based on its potential to utilise its resources and make profits. If profitability ratios are positive for a company, the stock has a better chance to provide good returns through dividends and capital appreciation.
However, it is important that you analyse a company and its stock based on other technical and fundamental factors along with profitability ratios. Now that you know the profitability ratio’s meaning, you are better equipped to make informed investment decisions.
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