Ratio Analysis and Interpretation: Profitability Ratios

To judge the overall financial health of a company, analysis of some ratios from the financial statements can prove to be useful. 

Ratio analysis is used to evaluate the relationship between financial statements. Various ratios can be used to identify trends over time for one company or to compare two or more companies. Additionally, ratio analysis helps you judge all the companies on the same metrics, despite the differences between their volumes of sales, the costs that they incur, etc.

Ratio analysis can be used for the following purposes:

• To evaluate performance over time
• To evaluate performance against industry average
• To evaluate performance against peers

There are four categories of ratios that will help you perform a critical evaluation and delve deeper into the figures mentioned in the financial statements. The categories are as follows:

1. Liquidity Ratio
2. Solvency Ratio
3. Profitability Ratio
4. Efficiency Ratio

Profitability Ratios:

The main objective of almost every business enterprise is to earn profit, which is necessary for not only ensuring the company's growth but also its survival. Therefore, profitability becomes the foremost thing that you associate with when you analyse the performance of any company or organisation. However, for business managers and investors, profitability has a different context. They analyse profitability with various elements, such as cost of goods sold, capital employed in the business, against competitors etc. for decision making.

Profitability ratios measure a company's ability to generate profit. 

The various types of margin profitability ratios are as follows:

Gross profit margin: It checks the profit left in the revenue from operation after incurring all direct costs.

• This ratio is important because it helps you understand whether the company's sales are sufficient to cover the cost of goods sold. 

• It is calculated using the following formula:

Gross profit margin	=	Revenue from operation − Cost of goods sold
		Revenue from operation

 

Operating profit margin: It shows the profit left in the total income after incurring direct costs and additional operating expenses.

• It is calculated using the following formula

Operating profit margin	=	Operating profit (EBIT)
		Total revenue

Net profit margin: It shows a company’s ability to generate earnings after paying taxes and interest expense.

• The higher the ratio, the better it is for the company.

• It is calculated using the following formula

Net profit margin	=	Net profit
		Net revenue

Return on Assets (RoA): It checks the effectiveness of assets in generating sales and net profit. 

• It can be calculated using the following formula:

Return on Assets	=	Net profit
		Total assets

Return on Equity (RoE): It measures the amount of net profit that a company is generating per unit of investment in equity. It also measures a company’s ability to earn returns for equity investors.

• It is calculated using the following formula:

Return on Equity	=	Net profit
		Shareholders′ equity

• If RoE > Ke (cost of equity), then it means that the firm has added value.

Return on Capital Employed (RoCE): It shows how well a company uses its sources of capital to generate returns.

• Returns should always be higher than the rates at which the company borrows funds.

• It is calculated using the following formula:

Return on Capital Employed	=	Net operating profit (EBIT)
		(Shareholders′ equity + Long−term liabilities)

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