Businesses often rely on numerical data to visualize their company’s sustainability and performance against its competitors. Profitability ratios are the true indicators of a successful business. It measures your business’ ability to generate profits using data from your sales revenue, shareholders’ equity, operating costs, and balance sheets.
The higher the profitability ratio, the better the performance. If your competitor has higher profitability ratios than you do, chances are, your company is lagging. Every business is categorized into industries, and it is important to compare your data with others to know if you are left out in the industry you belong to.
If you compare your ratio to your competitors’ ratio, you’ll fully understand how your business performs financially.
The 8 Types of Profitability Ratios
Before you can use profitability ratios to your advantage, you’ll need to learn how to calculate it. These ratios are good indicators of a well-performing company. The higher the results or ratio that you get, the more successful your business is.
Here are the eight different types of profitability ratios:
Return on Equity
This profitability ratio measures the profitability of the equity fund that was invested in the company. It can also calculate how much of the owner’s money was already used to generate company revenues.
The formula is Profit after Tax divided by Net Worth (Equity share capital and Reserve and Surplus)
The ordinary shareholder’s point of view is important since this ratio checks the profitability from the point of view of the shareholder.
The formula is Net Profit divided by Total Number of Shares Outstanding
This is the ratio that measures the amount of divided that is split among shareholders. A high ratio can signify that the company has surplus funds.
The formula is Amount Distributed to Shareholders divided by Number of Shares Outstanding
Price Earnings Ratio
Commonly used by investors, this ratio can be used to check if the share price of the company is overvalued or undervalued.
The formula is Market Price of Share divided by Earnings per Share
Return on Capital Employed
This is the percentage return of the company on the funds invested by the owners. The formula is Net Operating Profit divided by Capital Employed multiplied by 100
Capital Employed is also known as the equity share capital, reserve and surplus, debentures, and long-term loans. You can calculate it by subtracting the current liability from your total assets.
Return on Assets
This measures the earnings of assets invested in the company. Remember, a higher ratio means a better performing company.
The formula is Net Profit divided by Total Assets
To get the ratio of gross profit, you need to solve for gross profit. A good ratio means that the company is performing well.
The formula is Gross Profit divided by Sales multiplied by 100
You can solve the gross profit by adding sales and closing stock together and subtracting the OP stock, purchases, and direct expenses.
This ratio measures the overall profitability of a company by taking into account its direct and indirect costs. A higher ratio means that the company is making a profit.
The formula is Net Profit divided by Sales multiplied by 100
You can get the Net Profit by adding the Gross Profit to your Indirect Income then subtracting your Indirect Expenses from it.
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The Bottom Line
Staying up to date on your business’ financial ratios can be useful even if you’re not looking for investors any time soon. Profitability ratios are used to measure the financial performance of a company. But to truly grasp how your business is doing, it’s best to continuously track your profitability over time.
You can start by doing a small set of reports at regular intervals – monthly, quarterly, or yearly. As your company expands, you can add more details to your reports. If your finances allow, you can even hire a professional to calculate your ratios and help you analyze how your business can improve financially.
A good profitability ratio report should be able to answer the following questions:
- How much income does your company generate? How is it doing relative to your operating expenses?
- Is your ratio getting better or worse over time?
- Can your business perform better in a few month’s time?
- How is your company doing compared to your competitors’?
By analyzing different financial metrics, you can find ways to streamline your operations, increase sales, improve profitability, and ultimately increase your bottom line.