Profitability Ratio: Definition, Types, and Benefits

What is Profitability Ratio?

Profitability ratios are the ratios that offer an insight into a company’s ability to generate profits based on expenses and other costs associated with the generation of revenues in a particular time period. It is important because it represents the final position of a company vis-a-vis its profits.

Profitability ratios are very important for a company. The goal of all businesses in the world is to make profits. Without profit, a company cannot stay competitive in the market. Moreover, when there is a loss instead of a profit, the company should be aware of this. As profits form the backbone of the operation of a company, the utility of profitability ratios is beyond just calculating the profits. They are representative of a company’s true potential in terms of profitability and sustenance in the market.

Types of Profitability Ratios

The following are the types of profitability ratios −

Earnings Per Share

Earnings per share (EPS) offers the profitability of a company from the viewpoint of an ordinary shareholder. As the name suggests, it shows how much earnings an ordinary share has earned against the total net profit of the company. Investors consider EPS as a very important benchmark of a company’s performance.

The Earnings Per Share of a company is given as follows −

$$\mathrm{\mathrm{EPS}\:=\:\frac{\mathrm{Net\: Profit}}{\mathrm{Total \:number\: of \:outstanding \:shares}}}$$

Return on Equity

Return on Equity (ROE) measures the profitability obtained from the equity invested in a company. ROE also gives the measure of how profitably the owner’s equity has been used to generate the revenues of a company. The higher the ROE, the better is the financial condition of the company.

The Return on Equity is given as follows −

$$\mathrm{\mathrm{ROE}\:=\:\frac{\mathrm{ Profit\:after\:Tax}}{\mathrm{Net\:Worth}}}$$

Dividend Per Share

DPS offers the amount of dividend distributed to the shareholders. As the name suggests, the amount is obtained on a per-share basis. In simpler words, it gives the value of the dividend that has been offered per share by the company.

The Dividend Per Share is given as follows −

$$\mathrm{\mathrm{DPS}\:=\:\frac{\mathrm{Total\: amount\: of \:dividend\: distributed\: to\: shareholders }}{\mathrm{Total\: outstanding\: shares}}}$$

Return on Capital Employed

This ratio offers the percentage return a company gets from the funds invested in the company by its owners. The Return on Capital Employed is given as follows −

$$\mathrm{\mathrm{ROCE}\:=\:\frac{\mathrm{\left (Net \:operating \:profit/ \:Capital\: employed \right )}}{\mathrm{Capital \:employed}}\:\times 100}$$

Price Earnings Ratio

Price Earnings Ratio is used to check whether the shares are under or overvalued. It also indicates the expectation of the probable earnings or the period of payback to the investors.

Return on Assets

ROA calculates the earnings obtained per rupee of the amount invested in a project of a company. The higher the amount of ROA, the better it is because a higher amount indicates that the company generates better returns per rupee of the amount invested.

$$\mathrm{\mathrm{ROA}\:=\:\frac{\mathrm{Net \:profit }}{\mathrm{Total \:Assets}}}$$

Net Profit Margin

Net Profit Margin measures the profitability of a company taking into consideration of all direct and indirect expenses.

$$\mathrm{\mathrm{Net\: Profit\: Margin}\:=\:\frac{\mathrm{Net \:profit}}{\mathrm{Sales}}\:\times 100}$$

Gross Profit Margin

It is used to calculate the marginal profit or the segment revenue of a company. A higher ratio is an indicator of better company performance.

$$\mathrm{\mathrm{Gross\: Profit \:Margin}\:=\:\frac{\mathrm{\left (Gross\: Profit / Sales \right )}}{\mathrm{Sales}}\:\times 100}$$

Importance of Profitability Ratios

Profitable Ratio helps or benefits a company in the following ways −

  • Helps in Overall Profitability

    These ratios show the overall profitability of a company that indicates the performance of the company.

  • Helps in Prediction of Profitability

    Profitability ratios can be used to understand the future trend of profitability and can be a boon for better resource allocation.

  • Helps in Problem Indication

    The profitability ratios can show the grey areas of operation; thereby indicating the points of problems that need to be resolved.

  • Helps Saving Money

    These ratios indicate whether a new investment will be worth it or not, and hence saves money by cancelling investment in projects that aren't profitable.

  • Final Measure of Profitability

    Profitability ratios are the final measure of profitability, and cannot be skipped if a true measure of the company has to be ascertained.