What are profitability ratios in financial analysis

Financial analysts use various financial ratios to assess a company’s performance by analyzing financial statements and account balances. Being familiar with a company’s performance is vital to making managerial decisions, such as how to allocate resources and make the company more attractive to safe, high-return investments.

Profitability ratios are among the financial ratios used in financial analysis. To learn about the appropriate profit ratio for each case, continue reading the article to the end.

Quick Points (Useful Summary)

• Profitability ratios are a key indicator of a company’s financial performance. Through them, management can determine whether the company is achieving the expected profits or incurring losses.
   
• The profit ratio can be compared with the company’s prior-year ratios or with confirmed ratios from competitors in the same industry and target market.
   
• In addition to comparison with competitors and the company’s condition in previous years, the profit ratio helps in the early detection of problems.
   
• There are multiple ways to calculate profitability ratios: return ratios, profit margin ratios, and cash flow ratios, each with its own components and formulas that determine the profit ratio accurately.
   
• Methods of calculating profit margin include gross profit margin, operating profit margin, net profit margin, earnings before interest, taxes, depreciation, and amortization (EBITDA) margin, and profit margin before deducting tax value.

What is the profit ratio in financial analysis?

It is considered an indicator of the efficiency of a company’s financial policies and shows the company’s ability to generate periodic revenues, taking into account operating expenses and other aspects of the organization’s spending, and clarifying its financial performance.

Profitability ratios indicate whether profit trends in the organization are rising or declining and serve as useful benchmarks for financial analysis and comparative analysis. These ratios are less useful when viewed in isolation from competitors’ profitability ratios, the same project’s ratios from previous years, or the average profits within the company’s industry.

Use Daftra’s profit ratio calculator to find out the profit ratio in all your operations easily and for free.

What is the importance of profitability ratios?

It is necessary for companies to monitor changes and study trends in profitability ratios, whether upward or downward. The most prominent aspects of the importance of profitability ratios are as follows:

1- Increasing investments

Profitability ratios help show the gains achieved by the company, and good profitability ratios establish a positive impression among current investors. In addition, profitability ratios send reassuring signals regarding the company’s position and activities, which in turn attract more new investors and encourage current investors to increase their investments.

2- Detecting company problems

Profitability ratios contribute to providing a broader and more comprehensive view of company activities. As a result, they help uncover problems that may not be apparent from account statements and similar sources. Once these problems are identified, an opportunity arises to address them.

3- Comparison with competitors

Comparing the company with its competitors is beneficial in several ways, and comparing profitability ratios should not be overlooked during this process.

As with account statements, comparing profits alone does not provide a complete picture when assessing the company against its competitors, especially when the scale of the company's operations differs.

In such cases, comparing profitability ratios provides a more accurate indicator of the efficiency of the company’s current activities and the changes required to improve them.

4- Comparison with performance in previous years

Profitability ratios gain exceptional importance in the case of companies with seasonal activities, where profits vary noticeably from one period to another throughout the year.

The profit ratio highlights the company's peak activity periods, enabling more effective planning and resource allocation and better performance during those periods.

5- Providing a clearer picture of liquidity

The profit ratio clarifies the extent to which the company benefits from its sales profits in continuing its productive activities by converting them into liquidity. In addition, profitability ratios clarify how that liquidity is allocated, such as through investments.

What are the types of profitability ratios?

In general, profitability ratios can be divided into three main types: return ratios, profit margin ratios, and cash flow ratios. Each of these is further divided into several types. Profit ratios assess a company’s overall profitability, while return ratios evaluate the efficiency of its investments and the quality of its returns. The most prominent are reviewed below:

1- Profit margin ratios

These ratios are also referred to as profit-to-investment ratios. These investments may include the company’s assets, its investments, or shareholders’ investments in it. These ratios can be viewed as indicators of the efficiency with which the company manages its financial resources. Among the most prominent types of profit margin ratios are:
 

• Gross Profit Margin

The gross profit margin is one of the most widely used profitability ratios, linking total revenue from selling a product to the costs of manufacturing and selling it, thereby indicating the effectiveness of the company’s production process.

A high net profit margin indicates the company’s ability to price its products above competitors', suggesting the products have a competitive advantage. When calculating this ratio, it is necessary to consider whether the company’s activities are seasonal, meaning they naturally rise or fall during specific periods of the year.

The gross profit margin is calculated using the following formula:

Gross Profit Margin = (Revenue − Cost of Goods Sold) / Revenue × 100

You can download a model to calculate the gross profit margin easily; all you need to do is enter your data, and the model will calculate the ratio for you.

• Operating Margin

The operating margin is an indicator of the efficiency of the company’s operations. Its increase is associated with a greater ability to reduce fixed expenses and increase profits, and with the ability to sell goods at lower prices than competitors without incurring losses.

The operating margin identifies expenses that can be reduced without affecting the company’s operations or its ability to meet obligations, with the aim of increasing revenue and improving operating efficiency.

The operating profit margin is calculated using the following formula:

Operating Profit Margin = Net Sales − (Cost of Goods Sold + Selling Expenses + General and Administrative Expenses) / Revenue × 100

Daftra’s accounting software uses the income statement to collect profit data from operating activities after deducting operating costs, and then automatically calculates the profit margin.

• Net Profit Margin

Net profit reflects the company’s ability to generate revenues after deducting all taxes and expenses from gross profit. It is considered the most important criterion for measuring the company’s ability to control costs so it can generate profits from sales, and it also indicates its ability to withstand difficult economic conditions.

The profit ratio in this case is calculated by applying the following formula:

(Revenue − Expenses) / Revenue × 100

Caution should be exercised when relying solely on the net profit margin to determine a company’s profitability, because it takes into account all expenses, including those related to exceptional events such as the sale of an asset. Calculating such exceptional events may affect the comparison of profitability ratios with competitors.

• EBITDA Margin (Earnings Before Interest, Taxes, Depreciation, and Amortization)

This indicator measures the percentage of cash profit the company achieves in a given fiscal year, excluding the effects of depreciation, amortization, taxes, and other expenses not directly related to production.

A higher margin reflects higher company profitability. This margin can be calculated by dividing cash profit by total profit, excluding any expenses from the cash profit.

There are two methods to calculate the EBITDA margin ratio:

EBITDA = (Net Income + Interest + Taxes + Depreciation and Amortization Expenses) / Revenue × 100

EBITDA = (Revenue − Cost of Goods Sold − Operating Expenses + Depreciation and Amortization Expenses) / Revenue × 100

You can download a free model to easily calculate the EBITDA margin without accounting expertise.

• Profit Margin Before Deducting Taxes (EBT)

The profit ratio is calculated by deducting loan interest and operating and non-operating expenses from total revenues, so that the amount includes taxes not yet deducted.

This ratio is used for internal transactions and to monitor the company’s real growth over the years, and it also highlights risk points that affect the efficiency of operating activities.

EBT = (Revenue including tax expenses / Total Revenue) × 100

You can download a model to calculate earnings before tax (EBT) to calculate taxes easily and for free.

2- Return Ratios

They are also known as profit-to-sales ratios, and their focus is on measuring these two factors and the relationship between them—that is, measuring the extent to which the company generates profits from sales and the extent of its control over expenses related to sales. Return ratios are divided into several types, as follows:
 

• Return on Assets (ROA)

This return clarifies the company's net profits and their relationship to its assets. All costs, expenses, and taxes are deducted from revenue, and annual depreciation expenses are then added to calculate net profit.

Return on assets increases when the company’s acquisition of new assets reduces production expenses, so that profit growth exceeds asset growth. This return reflects the efficiency with which the company uses its assets to generate gains.

Return on assets can be calculated using the following formula:

Return on Assets = Net Income / Total Assets

Daftra’s system automatically calculates return on assets using data from the income statement and balance sheet. Its interconnected, integrated architecture computes all required formulas within seconds, delivering high-accuracy results.

• Return on Equity (ROE)

This indicator measures the company’s ability to generate profits from shareholders’ equity, which includes paid-in capital and common stock dividends, while preferred shares are excluded from the calculation of this return.

The return on equity ratio increases with net profit, indicating that the company is a good investment option because it generates returns on those investments.

• Return on Invested Capital (ROIC)

This profitability ratio expresses the percentage of profits generated by invested capital, in various forms such as financing, lending, and others. The return on invested capital can be calculated by dividing net profit by invested capital.

Investors rely on this return in valuation cases, and company management also uses it to assess the suitability of current capital allocation in generating returns for the company. Return on invested capital is considered a more advanced indicator than return on equity, as it includes a broader range of the company’s investment sources.

Read also: Compound return on capital and how to calculate it

Use the compound return calculator to analyze the rate of return on your investments automatically and for free.

3- Cash Flow Ratios

In addition to return ratios and profit margin ratios, a third, less common type of profitability ratio can be identified: cash flow or liquidity ratios. Liquidity ratios express the extent to which a company is able to convert sales profits into cash. Liquidity ratios are divided into two main types:
 

• Liquidity Margin

The liquidity margin reflects the movement of cash flows from operating activities over a specific period. The liquidity margin can be obtained by dividing cash flows by net revenues.

Liquidity Margin = (Cash flows from operating activities / Net revenues) × 100

Daftra’s system automatically calculates the liquidity margin by aggregating current assets and current liabilities and then applying the previously mentioned formula.

• Net Liquidity Ratio

The net liquidity ratio indicates whether the company needs more financing than it has.

Companies may experience temporary periods during which liquidity ratios are negative as a result of allocating liquidity to an investment; however, such investments are expected to have a positive impact on liquidity ratios over the long term.

When negative liquidity ratios persist for extended periods, the company incurs losses even if it is generating profits, as it may be forced to borrow to maintain operating continuity.

A practical example of how to calculate different profitability ratios

To clarify how to calculate the various profitability ratios, we will assume a company with assets valued at $800 and estimated sales of $1,000. The shareholders’ equity in this company amounts to $700. The company's total revenue is $400, operating profit is $200, and net income is $140.

• Calculation of return on total assets

Return on Total Assets (%) = (Net Profit / Total Assets) × 100

(400 / 800) × 100 = 50%

• Calculation of return on shareholders’ equity

Return on Equity (%) = (Net Profit / Shareholders’ Equity) × 100

(140 / 700) × 100 = 20%

• Calculation of gross profit margin

Gross Profit Margin (%) = (Total Revenue / Sales) × 100

(400 / 1,000) × 100 = 40%

• Calculation of net profit margin

Net Profit Margin (%) = (Net Profit / Sales) × 100

(140 / 1,000) × 100 = 14%

• Calculation of operating profit margin

Operating Profit Margin (%) = (Operating Profit / Sales) × 100

(200 / 1,000) × 10 = 20%
 

You can rely on Daftra’s accounting system, which enters financial data related to revenues and costs based on previous inputs in the system. It then calculates the different profit ratios (gross profit ratio, operating profit ratio, and net profit ratio).

Instead of taking risks and calculating them manually, you can rely on Daftra’s system to perform calculations automatically and generate financial reports periodically, enabling you to track financial ratios over different periods.

Daftra also provides a free discount rate calculator that allows you to calculate any discount rate from an amount or to know the value of the discount applied in a transaction.

Or download now the profitability indicator template for free editing from Daftra.

Frequently Asked Questions About Profitability Ratios

What is the minimum good profitability ratio?

Estimates of a good profitability ratio vary based on several factors, such as the type of profitability ratio used in the evaluation, the size of the company’s operations, and other distinctive characteristics.

In general, higher profitability ratios indicate better company performance and the possession of competitive advantages, such as low production costs.

For example, a minimum good operating profit margin is typically 1.5-2%, while a good net profit margin is typically above 5%.

These ratios are not fixed targets; achieving them does not guarantee that the company’s objectives are met; rather, institutions should continuously work to improve their profitability ratios.

Which of the different profitability ratios should be relied upon?

It is not recommended to rely solely on one profitability ratio to evaluate a company’s performance. Rather, data from multiple profitability ratios should be collected to assess the company’s situation from different perspectives.

By relying on various profitability ratios, it is possible to identify problems facing the company and areas of expense that can be rationalized and reallocated to improve performance or expand operations. On the other hand, no single profitability ratio alone provides a complete picture of the company and potential performance improvements.

How are profitability ratios analyzed?

The first step is to identify the types of profitability ratios that are most relevant to the company’s activity, field of work, and market size.

Next, compare the company’s current-year profitability ratios with those from previous years and with those of competitors. By tracking performance across different levels, weaknesses become apparent and can be addressed to improve performance.

How can profitability ratios be improved?

Companies constantly seek to increase their profitability ratios as much as possible, and to achieve this, they may resort to one or more of the following policies:

• Eliminating unprofitable products: If financial analysis shows that a product consistently incurs losses, discontinuing it may improve profitability ratios.
• Reducing expenses: Explore methods to cut unnecessary company expenses to improve profitability. For example, indirect expenses unrelated to production can be reduced.
• Increasing product or service prices: The company may need to raise prices to improve profitability.

What is the difference between profit and profitability?

Profit refers to the amount earned by the company at the end of a financial period after deducting all expenses and taxes.

In contrast, profitability is a more comprehensive measure of the company’s ability to generate profits both currently and in the future. It is worth noting that both concepts are useful for assessing the company’s situation and evaluating its performance despite their differences.

How is the profit ratio calculated?

The profit ratio is calculated by dividing net profit by total revenues and then multiplying by 100%.

What is the ideal profitability ratio?

There is no fixed profitability ratio. An ideal profit ratio depends on several factors, including the type of business activity, company size, economic conditions, and other factors.

What is the formula for the profit and loss ratio?

The profit ratio formula is: (Profit / Cost Price) × 100
The loss ratio formula is: (Cost Price − Selling Price)

How can I calculate the cumulative profit ratio?

The cumulative profit ratio is the sum of profits over certain periods minus the original capital invested in the company.

Cumulative Profit Ratio = (Total Amount) − (Original Amount)

What is the profit margin in the clothing trade?

The profit margin in the clothing trade ranges between 20% and 50%, depending on the type of activity, sales volume, and economic conditions.

How can I calculate the dividend payout ratio?

The dividend payout ratio is calculated by dividing the total distributed profits by net income and multiplying by 100%.

Accounting formula:

Dividend Payout Ratio = (Total Distributed Profits / Net Income) × 100%

How to calculate the cost price from the profit margin?

The cost price from the profit margin is calculated by dividing the product cost by (1 − profit margin). Use the following formula to calculate the cost price from the profit margin:

Selling Price = Product Cost / (1 − Profit Margin)

What is the profit margin in investment?

The profit margin in investment is calculated using the following formula:

Profit Margin = (Net Profit / Investment Cost) × 100

How can I calculate the profit margin in stocks?

The profit margin in stocks is calculated by subtracting the purchase price of the stock from its selling price. The calculation formula is:

Profit Margin = ((Selling Price − Purchase Price) / Purchase Price) × 100%

What is the profit ratio formula?

Profit Ratio = (Net Profit / Total Revenues) × 100

What is the profit margin in trading?

The profit margin in trading is a percentage that shows the expected profit. Factors affecting profit margins in trading include the trading strategy's short- or long-term orientation, trading experience, and the effectiveness of risk management, taking into account market conditions and volatility.

What is the profit margin in the food trade?

The profit margin in the food trade ranges from 10% to 30%, depending on product type, market conditions, and geographic location.

How is the profit margin calculated in banks?

The profit margin in banks is calculated using the following formula:

Profit Margin = Gross Profit − Deposit Interest

What is the profit margin in Saudi banks?

The profit margin in Saudi banks varies depending on the type of financing. Details:

• Real estate financing rates range from 2.99% to 4.32%.
• Credit card rates range from 38.36% to 48.02%.
• Savings accounts have a lower profit margin than credit cards.

What does profit margin in financing mean?

The profit margin in financing is the percentage that indicates the difference resulting from subtracting financing costs from revenues.

How to calculate the cost price from the selling price and profit margin?

The cost price from the selling price and profit margin is calculated using the following formula:

Cost Price = Selling Price / (1 + Profit Margin)

Conclusion

Profitability ratios are used in financial analysis to assess a company’s ability to generate profits relative to its assets and competitive advantage, while accounting for operating expenses, taxes, and other financial obligations.

Each profitability ratio provides a piece of the overall picture that company managers and investors need to identify the most effective ways to use resources, enabling the highest profit margin.

It is essential not to rely on a single profitability ratio when evaluating company performance, while taking into account the company’s average profits over previous years and competitors' profits when making comparisons.