Types of Profitability Ratios

Profitability ratios are very important ratios because they show the amount of profit made by the company on the sales done by the company and also return earned on the assets or capital employed by the company. Profitability ratios can be compared with the pulse of a human being just like by measuring the pulse one can get the idea whether everything is right with the human body or not, in the same way looking at profitability ratios one can get an idea whether everything is good or not with the company. There are many types of profitability ratios, given below is the list of profitability ratios –

  1. Gross Profit Ratio – It is calculated as Gross profit/ Net sales *100 where gross profit is calculated as Sales – cost of goods sold and net sales is calculated as total sales – sales return. This ratio comes in percentage form and higher the ratio the better it is for the company.
  2. Net Profit Ratio – It is calculated as Net Profit/ Net sales *100 where net profit figure comes after deducting all operating and non-operating expenses from gross profit figure and adding non-operating and operating income to gross profit figure and net sales figure remain same as used in gross profit formula. Higher the ratio the better it is, however, this ratio will always be lower than gross profit ratio.
  3. Operating Profit Ratio – It is calculated as Operating Profit/ Net sales *100 where operating profit is calculated by adding non-operating expenses and deducting non-operating income from net profit. This ratio typically measures the operating performance and efficiency of the company. A higher net profit ratio but lower operating profit ratio is indicative of the poor operational performance of the company as profit has increased due to other income and not due to operating or business income.
  4. Return on Assets – It is calculated as Net profit/ Average total assets where net profit is same as calculated in net profit ratio while average total assets can be calculated as total assets in the beginning plus total assets at the end divided by 2. A higher ratio implies that company has been utilizing its asset productively and efficiently whereas a lower ratio would mean that company has not been able to use its asset base judiciously.
  5. Return on Equity – It is calculated as Net profit after preference dividends/ Shareholders Equity where shareholders equity is calculated by subtracting total liabilities from total assets. This ratio measures how the company is using the shareholder’s fund and higher the ratio the better it is as far as investors are concerned. Hence in a way this ratio is more useful for investors than the company because it helps the investors in knowing whether their capital is used properly or not.

As one can see from the above that profitability ratio is very important and if the company’s profitability ratios are not good then the company can be in big problem as it is the profitability which decides the fate of company as without profits no company can survive and grow.

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