Profitability ratios definition
/What are Profitability Ratios?
Profitability ratios are a set of measurements used to determine the ability of a business to create earnings. These ratios are considered to be favorable when they improve over a trend line or are comparatively better than the results of competitors. Profitability ratios are derived from a comparison of revenues to difference groupings of expenses within the income statement. A different class of profitability ratios compare the results listed on the income statement to the information on the balance sheet. The intent of these latter measurements is to examine the efficiency with which management can produce profits, in comparison to the amount of equity or assets at their disposal. If the outcome of these measurements is high, it implies that resource usage has been minimized. These ratios are noted below.
When using profitability ratios, it is best to compare a company's results for the current period to the results for the same period in the preceding year. The reason is that many organizations have seasonal revenues, which causes their profitability ratios to vary considerably over the course of a year.
Contribution Margin Ratio
The contribution margin ratio subtracts all variable expenses in the income statement from sales, and then divides the result by sales. This is used to determine the proportion of sales still available after all variable expenses to pay for fixed costs and generate a profit. This is used for breakeven analysis. The contribution margin is only found on a contribution margin income statement, which is rarely reported. The formula is:
(Sales - Variable expenses) ÷ Sales = Contribution margin ratio
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Gross Profit Ratio
The gross profit ratio subtracts all costs related to the cost of goods sold in the income statement from sales, and then divides the result by sales. This is used to determine the proportion of sales still available after goods and services have been sold to pay for selling and administrative costs and generate a profit. This ratio includes the allocation of fixed costs to the cost of goods sold, so that the result tends to yield a smaller percentage than the contribution margin ratio. Also, since the ratio is derived from both fixed and variable expenses, the profit percentage tends to increase as sales go up, since the fixed expenses are covered by initial sales. The formula is:
(Sales – (Direct materials + Direct Labor + Overhead)) ÷ Sales = Gross profit ratio
Net Profit Ratio
The net profit ratio subtracts all expenses in the income statement from sales, and then divides the result by sales. This is used to determine the amount of earnings generated in a reporting period, net of income taxes. If the accrual basis of accounting is used, this can result in a figure that is different from what cash flows would indicate, due to the accrual of expenses for which payments have not yet been made. The formula is:
(Net profit ÷ Net sales) x 100 = Net profit ratio
Return on Assets
The return on assets divides net profits by the total amount of assets on the balance sheet. The measurement can be improved by using a tight credit policy to reduce the amount of accounts receivable, a just-in-time production system to reduce inventory, and by selling off fixed assets that are rarely used. These asset reduction policies can have a negative effect on profits, however, if they adversely impact operations. The result varies by industry, since some industries require far more assets than others. The formula is:
Net profits ÷ Total assets = Return on assets
Return on Equity
The return on equity divides net profits by the total amount of equity on the balance sheet. The measurement can be improved by funding a larger share of operations with debt, and by using debt to buy back shares, thereby minimizing the use of equity. Doing so can be risky, if a business does not experience sufficiently consistent cash flows to pay off the debt. The formula is:
Net income ÷ Equity = Return on equity ratio
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