CA Foundation Exam June 2023 » CA Foundation Study Material » Accountancy » Profitability Ratios

Profitability Ratios

A financial ratio is very much effective to understand the financial conditions of a firm or a company. The profitability ratio is one of the important accounting ratios to understand a company's profit percentage and future growth.

In financial analysis, part ratio analysis is one of the most important and effective lessons to understand the company’s financial stability and growth. From ratio analysis, one can easily understand the company’s past, present, and future. There are five basic types of ratios called Profitability ratio, Liquidity ratio, Activity ratio, Debt ratio, and Market ratio. These ratios are used to evaluate the overall financial conditions of an organization. An evaluation using the Profitability ratio formula; makes easy decisions about a company’s financial statements.

Definition

The profitability ratio is the basic financial matrix that is used to assess the organization’s ability to generate earnings relative to its income, operating costs, and assets. Profitability ratios are also sometimes compared with efficiency ratios and they calculate the organization’s use of its assets to generate income. And it’s completely opposed to the theory of after-cost profits.

Effects of Profitability Ratio

  • After using the profitability ratio formulas if the analyst gets data which is maybe higher or equal to the ratio as per the previous financial year; it defines that the company is doing very well
  • A Profitability ratio is used most of the time when a comparison has happened between two similar kinds of organizations, between companies past and present, for calculating the average ratio of organization industry
  • The Profitability ratio shows the differences between organizations’ revenue and their cost of production which is also called the cost of goods sold
  • The Profitability ratio also helps to understand the market demands, especially for seasonal businesses like at the time of peak selling; the quarter shows good growth in gross profit margin
  • But whereas on the other quarters of the financial year; it shows not likely for that particular season
  • So for the seasonal businessman who wants to point out the peak selling season; the profitability ratio formula can help them out
  • The Probability ratio formula helps to calculate the net profit of the organizations
  • If the organizations want to analyze their net profits from their past to present to understand their financial stability; what is profitability ratio can help to evaluate

Formula

There are 3 most used and common profitability ratios. They are used by the organizations to analyze their net profit and understand their financial statement of the organizations. 

1. Profit margin = Net Income / Sales

Profit margin is an easy way to calculate the profitability ratio to understand how much the organization’s income is from the sales. Calculating the revenue of the organizations from sales is the best way to understand companies’ revenue from the past and present. Also, an easy way to make differentiate between similar organizations is by using the profitability ratio formula.

2. Return on assets = Net Income /  Total Assets

This profitability ratio formula helps to understand the company’s asset competition. How much asset value is increased or decreased can easily evaluate what profitability ratio makes very efficiently. By using the profitability ratio formula; from increase or decrease in assets easily indicate the company’s growth and its financial statements.

3. Return on Equity = Net Income /  Stockholders’ Equity

This profitability ratio helps to identify the investment of stockholders. By using this profitability ratio formula the analyst can easily understand the organization’s investment situation. Previous year’s profitability ratio the shareholders can clearly understand the scenario of their investment between the past and present with respect to the company.

Net Profit 

Net Profit Ratio = Net profit / revenue

Net profit margin is very important to understand the profitability ratio of the organizations. Without calculating the net profit ratio it is quite impossible to understand a company’s profitability in a few previous years. 

Conclusion

From the app of discussions, it’s clear the use, importance, and implications of profitability ratios in accounting ratios or financial ratios. Net profit margin and EBITDA margin ratios help to understand and calculate the profitability ratio of an organization. If anyone wants to analyze or understand any of the company’s financial situations and profit margins and investment profitability ratio is the best way a can help them to understand. By using the profitability ratio formula and net profit ratio anyone can easily understand the financial structure of the company and its growth.