Profitability Ratio — Microsoft Excel
In this article, we will walk you through the fantastic journey of learning profitability ratio, we also have doubt that our business is in profit or not, now here’s is the solution, profitability ratio is help us to identify our profit ratio of sales of products and other different categories like softwares, games, laptops and so on. It is very helpful to calculate the company profit and through this we can also analyze, is our company is in profit or loss.
Profitability Ratios
Profitability ratios evaluate a business’s ability to make profit from its operations. The higher the profitability ratios are, the better the indication that a company is going in the right direction. These ratios show us the financial performance of a business and the direction a business is going in.
It has two types:
- Return on Sales
- Return on Investments
Return on Sales
Every company wants to know how much they have earned over a period, along with the profit percentages at each stage of the income statement, the bottom line percentages and the top line percentages. In an income statement, total sales are the
top line, while net profit is the bottom line.
There are various types of return on sales ratios:
- Gross Profit Margin
- Operating Profit Margin
- Pre-tax Margin
- Net Profit Margin
All ratios are to be calculated in percentages.
Gross Profit Margin
The gross profit margin is calculated by subtracting direct expenses or Cost Of Goods Sold (COGS) from net sales.
Formula:
Where Gross Profit (GP) is as per the income statement and total sales indicates total revenue or total turnover. Let’s take an example to understand this better by looking at the figure below.
As we can see in the above figure, the gross profit margin is 70%.
Where operating profit is EBIT as per the income statement and total sales indicates total revenue or total turnover. Let’s take an example to understand this better by looking at the figure below.
As we can see in the above figure, the operating profit margin is 50%.
Pre-Tax Profit Margin
The pre tax profit margin is calculated by subtracting interest expenses from EBIT or subtracting direct expenses, COGS, operating expenses, and interest from total sales.
Formula:
Where profit before tax is a component of the income statement and total sales
indicates total revenue or total turnover.
Let’s take an example to understand this better by looking at the figure below.
It shows that the net profit margin is 28%.
Return on Investment (ROI)
Return on investments are different types of ratios that indicate gain or loss on an
investment. ROI can be negative or positive. We use both the income statement and the balance sheet for calculating ROI.
Types of ROI:
- Return on Equity
- Return on Common Equity
- Return on Capital Employed
- Return on Assets
Return on Common Equity
It indicates how well a company is generating profit from common equity. The return on common equity is calculated as a company’s net income, after paying preferred dividends divided by its common equity.
Formula:
Where net profit is NP from income statement, preferred dividends are dividends paid to preferred equity shareholders and common equity is the sum of shareholders’ funds and reserves and surplus excluding preferred equity. Let’s take an example to understand this better by looking at the figure below.
Return on Capital Employed (ROCE)
It indicates how well a company is generating profit from the capital employed. The return on capital employed is calculated as a company’s EBIT divided by the capital employed.
Formula:
Where EBIT is the operating profit as in the income statement and capital employed is the sum of shareholders’ fund, reserves and surplus, preferred equity and debts or capital employed is total assets minus total equity and liabilities.
Let’s take an example to understand this better by looking at the figure below.
As we can see in the above figure, the return on capital employed is 36%.
ROE vs ROCE (Return on Equity vs Return on Capital Employed)
- ROE does not give the overall picture of returns on capital.
- ROE can be manipulated, more debt can be shown to increase ROE.
- ROCE gives the overall return on the total capital employed in the business.
- ROCE can be compared to the return from other investments.
Return on Assets (ROA)
It indicates whether a company is generating profit from its assets. The return on assets is calculated as a company’s net profit divided by total assets.
Formula:
Where NP is Net Profit from income statement and total assets is current assets plus non-current assets. Let’s take an example to understand this better by looking at the figure below.
The above figure, shows that the return on assets is 18%.
Conclusion
As we anywhere heard a term profit than its obvious to understand it is very important for a company or business and when we thinking about its calculation than we will use the profitability ratio because it help us to calculate and identify the ratio of profit in our business or company and we also discussing further more sub-types, like return on Sales and return on Investment and we also have a look how it helpful for us, when we try to find out profit ratio of our products sales.
