Profitability ratios help understand the profitability of a business at different stages of the income statement. For instance, the gross profit ratio helps to understand how efficiently the company has controlled direct costs. Similarly, the net profit margin includes all types of expenses, including direct, and indirect. Hence, it’s about controlling all types of expenses in comparison to revenue.
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Explanation of profitability ratios
Earning profit is one of the primary purposes of business management. However, it isn’t easy to assess the profit position of the business without comparing it with the peer companies, trend analysis, metrics, and other factors.
Metrics have been designed with a logical basis to assess the performance of the business. These metrics compare profitability with the different rational bases. For instance, profit is compared with the revenue, equity, and other account balances to assess how the business has performed. Let’s analyze different types of ratios and evaluate them with related interpretations.
Gross profit margin-GPM
Gross profit margin compares gross profit with the revenue generated by the business. Gross profit is calculated by deducting direct cost (cost of sales) with the income. So, if the cost of sales is lower gross profit is expected to be more significant. Hence, leading to improved gross profit.
In easy words, the GPM helps assess if the business has efficiently controlled the cost of sales. Comparing GP Margin with other companies and peers helps to understand the business profitability further.
The formula to calculate gross profit margin is given below.
Gross profit margin = Gross profit/revenue.
It’s important to note that net revenue is used in the formula to calculate the gross profit ratio.
Net profit ratio – NPM
Net profit margin compares net profit with the revenue. It helps to understand how business has controlled overall business expenses, including administrative, operational, marketing, and financing expenses. In addition to this, a detailed break-up of the expenses can also be helpful in a simple comparison with the revenue base of the business.
Further, this ratio accounts for types of expenses and compares with the net revenue. Hence, it can be constructive in the assessment of the expense controlling mechanism. The formula to calculate the net profit margin is as follows.
Net profit margin = Net profit/Revenue.
Return on capital employed – ROCE
Return on capital employed is calculated by comparing earnings before interest and tax with the revenue generated by the business. It’s an accurate assessment of the profit-generating ability of the business with the implied resources. It’s more logical to use this metric as comparing the performance of the small business with the large business does not seem logical. The formula to calculate ROCE is as follow,
ROCE = Earnings before interest and tax/capital employed
Profitability ratios help assess the business’s performance, and it helps assess control activities as well. It’s a prime picture of the business to understand the proportion of the revenue earned and the expenses incurred.
Controlling expenses and increasing revenue is considered an excellent performance matric. Further, a detailed analysis of the expense helps understand where improvement needs to be made to take corrective actions.