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7 Min. Read

What Are Profitability Ratios? Definition, Types & Importance

What Are Profitability Ratios? Definition, Types & Importance

A profitability ratio is a financial measurement. It measures the relationship between revenues and costs. The ratio quantifies the cost levels required to achieve these revenues. They can be applied at different levels within an organization or industry. This depends on the situation that needs to be analyzed. There are many types of financial ratios. This article will discuss many of them.

Here is an important thing to note. Profitability ratios are just one aspect of the business situation. It is not enough to look at only profitability ratios. When analyzing a company's future, there are many factors involved. It's important to keep this in mind during your financial analysis. Profitability ratios can be used in combination with other financial information. Some other examples are asset utilization, liquidity, capital structure and return on assets. Other key metrics include return on equity and return on investment.

This article will also explain profitability ratios, what they are used for and more!

In this article, we’ll cover:

What is a Profitability Ratio?

What Are the Three Main Profitability Ratios?

Which is the Best Profitability Ratio?

What is Considered a Good Profitability Ratio?

Focusing on the Wrong Types of Profitability Ratios

Key Takeaways

What is a Profitability Ratio?

A profitability ratio is a measurement. It measures the profitability, efficiency and effectiveness of an organization. The ratio of profitability is an efficiency ratio. It measures the percentage of revenue available after all operating expenses are deducted. Profitability ratios differ from other balance sheet ratios in one keyway. They are specific to income statement items.

The current ratio can help you understand if a company can convert sales revenue into net income. The primary purpose of profitability ratios is to measure how a company uses its assets. It signifies how well it generates profits.

High profitability ratios are desirable. They mean that the company has generated high levels of profit with fewer assets or lower asset use.

Low profitability ratios are undesirable. This means the company has missed opportunities. These opportunities could increase profits through better asset management.

High profitability ratios are always good. They show a high level of efficiency. Low profitability ratios are usually bad, but not always. Low profitability can suggest that the organization is in a growing phase. It may be operating in a very competitive industry.

It has quite a few uses. Some of these include:

  • Profitability ratios can be used to compare many companies.
  • It can help decide if someone should invest in a company.
  • Business owners or managers can use it to determine how much money should be invested.
  • They can help determine how you use your cash flows
  • They can help determine your cash return
  • And more

What Are the Three Main Profitability Ratios?

Profitability ratios can be classified into three types. These are operating profitability, asset use and contribution. Business performance profitability ratios focus on the income generated by a company. They provide information about what part of sales revenue is available for expenses. This is an important number in your expense ratio. This is after all production costs of goods sold have been deducted from total revenues.

Operating Profitability Ratio

This profit ratio determines how well a company is able to generate sales revenue. This is after deducting the cost of goods sold. The operating profitability ratio can be calculated as follows. Divide net income by sales.

Operating Profitability Ratio = Net Income/Sales

Asset Use Profitability Ratios

Asset use ratios focus on assets. This includes total assets and fixed assets. These are used to generate sales revenue. They're calculated after all operating costs have been deducted from revenues. There are two types of asset use profitability ratios. These are the fixed asset turnover ratio and the inventory turnover rate.

  • Fixed Asset Turnover Ratio. This measures how effectively a company uses its fixed assets. This is calculated by dividing total revenue by total fixed assets.
  • Inventory Turnover Rate. The inventory turnover rate measures how effectively a company uses its inventory. This is calculated by dividing net sales revenues by average inventory.

Contribution Profitability Ratio

The contribution profitability ratio helps companies measure the effectiveness of their marketing efforts. The contribution margin is also known as gross profit or revenue less cost of goods sold. This is what's leftover after deducting the cost of goods sold from total revenue.

Contribution Margin = Revenue - Cost of goods sold/Revenue

Divide net income by contribution profit margin to get the contribution profitability ratio. This will tell you how much is available for distribution as dividends per share.

Which is the Best Profitability Ratio?

Profitability ratios measure a company's ability to convert sales revenue into net income. It's important to take other factors into consideration. An example is gauging which profitability ratio is best.

The operating profitability ratio is often considered the best one out of the three. It tells an organization how well it manages its costs. This is after all operating expenses have been deducted from sales.

The contribution profitability ratio is useful for marketing purposes. Most companies use it to measure effectiveness. This includes marketing efforts and marketing budgets.

What is Considered a Good Profitability Ratio?

Net income before taxes is the norm when it comes to measuring a company's profitability. Average net earnings keep increasing. This is often because companies adopt cost-saving strategies and new technology.

As a rule of thumb, a good operating profitability ratio is anything greater than 1.5 percent. The industry average for most countries around the world hovers closer to 2 percent. A good net income ratio hovers around 5 percent.

For a contribution margin, it's best to use as long as the percentage is increasing overtime periods. The more efficient a company becomes, the better its profitability will be.

A business often has to choose between increasing sales revenue and increasing profit. Doing both is very difficult. It requires too much of a strain on operating expenses. Some examples are marketing, distribution, inventory management and administration. This is why it's important to know the best profitability ratio for your company.

Focusing on the Wrong Types of Profitability Ratios

Using one kind of profitability ratio over another can be a disadvantage.

One example is if your business is one of many companies in the industry. Using operating profit margin as a measure for profitability can be counter-productive. This is because you're comparing yourself with different organizations. They may have access to different types and quantities of assets and labor.

It's best to use contribution margins as a measure for profit as well as productivity. Compare your profit to the rest of the industry's when competing with other companies.

Using this profit margin ratio will give you insights about the direction your company is moving.

Key Takeaways

Profitability ratios help any business measure the differences between income and expenses. It's a good measure of financial performance. When used correctly, this makes it easier to identify where a company can reduce costs. It can also help identify areas to increase revenue. This is particularly useful for smaller businesses. This is because they do not have access to as much capital as larger ones.

Profitability ratios allow companies to better understand their short-term and long-term prospects. It allows them to build a better business plan. It also helps make the difficult decisions needed at all stages of a company's lifecycle. It is important to take other factors into consideration. This helps when gauging which profitability ratio is best. Operating margins help measure a company's ability to convert revenue into net income.

This article discussed profitability ratios in depth. You learned what profitability ratios are, which ratio is best and much more. Hopefully this guide answers all of your questions about profitability ratios.

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