What are the types of profitability ratios? Explain with formula and example?

 

Profitability ratios are a group of financial metrics that are used to measure a company's ability to generate profits. There are several different types of profitability ratios, including:

Gross Profit Margin: 

This ratio measures the percentage of revenue that a company retains after deducting the cost of goods sold (COGS). It is calculated by dividing gross profit by revenue. A higher ratio indicates that a company is generating more profit from its sales.

Example: A company has revenue of $1,000,000 and COGS of $800,000. The gross profit margin would be calculated as: 

Gross Profit Margin = Gross Profit / Revenue Gross Profit Margin 

= (1,000,000 - 800,000) / 1,000,000

 Gross Profit Margin = 0.2 or 20% 

This ratio of 20% indicates that the company is retaining 20 cents of every dollar of revenue as gross profit.

Operating Profit Margin: 

This ratio measures the percentage of revenue that a company retains after deducting all operating expenses, including COGS and SG&A (selling, general and administrative expenses). It is calculated by dividing operating profit by revenue. A higher ratio indicates that a company is generating more profit from its sales after accounting for all operating expenses.

Example: A company has revenue of $1,000,000, COGS of $800,000 and SG&A of $200,000. The operating profit margin would be calculated as: 

Operating Profit Margin = Operating Profit / Revenue 

Operating Profit Margin = (1,000,000 - 800,000 - 200,000) / 1,000,000 

Operating Profit Margin = 0.1 or 10% 

 

This ratio of 10% indicates that the company is retaining 10 cents of every dollar of revenue as operating profit after accounting for all operating expenses.

Net Profit Margin: 

This ratio measures the percentage of revenue that a company retains after deducting all expenses, including COGS, SG&A, and taxes. It is calculated by dividing net income by revenue. A higher ratio indicates that a company is generating more profit from its sales after accounting for all expenses.

Example: A company has revenue of $1,000,000, COGS of $800,000, SG&A of $200,000 and taxes of $100,000. 

The net profit margin would be calculated as: 

Net Profit Margin = Net Income / Revenue 

Net Profit Margin = (1,000,000 - 800,000 - 200,000 - 100,000) / 1,000,000 

Net Profit Margin = 0.05 or 5% This ratio of 5% indicates that the company is retaining 5 cents of every dollar of revenue as net profit after accounting for all expenses.

Return on Equity (ROE): 

This ratio measures the return that a company generates for its shareholders. It is calculated by dividing net income by shareholder's equity. A higher ratio indicates that a company is generating more profits for its shareholders.

Example: A company has net income of $100,000 and shareholder's equity of $1,000,000. The ROE would be calculated as: 

ROE = Net Income / Shareholder's Equity 

ROE = 100,000 / 1,000,000 ROE = 0.1 or 10% 

This ratio of 10% indicates that the company is generating a 10% return for its shareholders.