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What is the Importance of Profitability Ratio?
What is Profit?
Profit is the difference between revenues and expenses, and it is the ultimate aim and output of a company. Profit is the fuel that propels businesses. A company must earn enough profits to sustain and grow. In order to make an expansion too, a company must earn enough profits so that it can accumulate earnings and invest them in an expansion project. Investors and lenders invest money in a company to get profitable returns. Without profit, no company can last for a long period of time. So, it is an item no company should avoid.
However, it is inappropriate to try to maximize profits at any cost. A company and its management must look at the impact of profit maximization and skip projects that are harmful to society. However, it is true that some companies just go for profit maximization without caring for all stakeholders. Such practices should be avoided in order to remain profitable yet socially responsible.
Without sufficient profit, the future of a company will be dark. In fact, if the company fails to earn profit for a long time, it will have no future.
Therefore, it is important to keep an eye on the present and future profits of the companies. It is here where the profitability ratios come into picture.
What is Profitability Ratio?
The profitability ratios calculate the operational efficiency of a company to derive profits. In other words, the profitability ratios measure the true profitability of companies under consideration for a long period of time. This helps the company owners stay aware of the position of the company and if the conditions are bleak, they may take corrective measures.
Besides the management of the company, all other stakeholders are also interested to compare the profitability of competitors. In order to do so, profitability ratios of different companies from the same industry may be compared. Profitability ratios offer the true picture of a company’s relative financial condition and so, it implies the profitability of company by comparing the various financial items that may be obtained from the company documents.
Types of Profitability Ratios and their Importance
There are mainly two types of profitability ratios, they are as follows −
Sales-Related Profitability Ratios include -
- Gross Profit Margin
- Net Profit Margin
- Net Operating Profit After Tax (NOPAT), and
- Operating Expense Ratios.
Gross Profit Margin
Gross Profit Margin shows the efficiency of a company in producing each product. It compares the cost of goods with revenues. When this is subtracted from 100, the percentage of the cost of goods sold is obtained. Both of these ratios show the profit in comparison to sales after the subtraction of production costs.
Net Profit Margin Ratio
Net Profit Margin ratio connects net profits and sales and shows the efficiency in manufacturing, producing, and selling the product in the market. The net profit margin ratio also indicates the capability of a company to sustain adverse economic conditions.
Net Operating Profit After Tax (NOPAT)
NOPAT is based on the idea that calculating the tax shield is important for companies. So, the Net Profit Margin is adjusted for taxes and then the ratio is calculated. NOPAT shows all the effects that are shown by the Net profit margin.
Operating Expenses Ratio
Operating expenses ratio forms a relationship between operating expenses and sales. It lets the management check whether any discretionary expenses have occurred due to the management’s wrong role-play. Otherwise, the operating expense ratio shows how efficient the company is vis-a-vis its sales.
Investment-Related Profitability Ratios include -
- Return on Investment, and
- Return On Equity.
Return on Investment (ROI)
The conventional method of obtaining ROI is to divide PAT by investment. However, the calculation of Return on Total Assets and Return on Net Assets are considered to be better to calculate and compare the operating efficiency of company’s vis-a-vis total assets and net assets.
Return on Equity
Return on equity is given by net profit after taxes divided by shareholder’s equity. It shows the effectiveness with which the management has acted to utilize the resources of the company.
So, this is briefly how all the profitability ratios are calculated and how they impact the bottom line of a company.
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