Profitability Ratio: Types and Formula

What is Profitability Ratios

Let’s start with the fourth classification of financial ratios, i.e. profitability ratios. This category of ratios aims to measure the overall performance of the firm’s profitability relative to revenues, assets, equity, and capital. It helps determine the firm's performance on various profitability levels like gross, operating, net, etc. 

Net Profit Margin 

It is the ratio of net profit to revenue. It's one of the key indicators that aims to measure the ability of the firm to convert its sales into profits. As discussed earlier, the numerator of the ratio is the net income, which is the ultimate profit that the company earns after deducting all the expenses. 

Formula of Net Profit Margin:

Net Profit Margin = Net income/revenue 

Interpretation of the Net Profit Margin ratio: 

• A higher net profit ratio indicates higher profitability of the firm. 
• You, as an investor, should be concerned if this ratio is too low. A lower ratio means that the take-home profit for shareholders as a proportion of revenue is less. 

Of course, just like any other ratio, this ratio should be compared with its historical average and peers. 

Gross Profit Margin

It is the ratio of gross profit (revenue from operations less cost of goods sold) to sales. This measures the efficiency of a company in managing its production costs. This ratio is critical as you learn about the company's pricing power. How is it possible? In inflationary pressure, the company's cost of goods sold increases due to increased input costs. In such an inflationary environment, if the company can maintain its gross profit margins, it means that the company has good pricing power. This is so because the company was successfully able to pass on the increase in prices directly to customers. 

Formula of Gross Profit Margin:

Gross Profit Margin = Gross profit/revenue 

Interpretation of the Gross Profit Margin ratio: 

• You should be concerned if this ratio is too low, as it may suggest challenges in cost control. 
• Gross profit can be increased by either raising prices or reducing costs. However, the ability to raise prices may be limited by competition.

Operating Profit Margin

The problem with gross profit is that it ignores operating expenses like selling and general and administrative expenses. That’s why the need for an operating profit margin arises. This is the operating profit ratio (gross profit less operating expenses) to sales. This measures profitability relative to funds invested in the company by various suppliers of capital like common stockholders, preferred stockholders, and suppliers of debt financing. The measure of operating profitability is EBIT, as discussed in the chapter on profit and loss. 

Formula of Operating Profit Margin:

Operating Profit Margin = EBIT / Revenue 

Interpretation of the Operating Profit Margin ratio: 

• A higher ratio indicates a greater ability of the firm to generate profits from its core business activity. 
• A lower ratio may suggest challenges in controlling operational costs. 

Return on Assets (ROA)

This ratio measures a company's ability to generate profits from its assets. It’s also a measure of efficiency because it measures how well the company can utilise its assets to generate profits. Typically, ROA is calculated using net income. 

Formula:

Return on Assets = Net income / average total assets 

Interpretation of the Return on Assets ratio: 

• A higher ROA ratio indicates that a company is more efficient in generating profit from its assets. 
• A lower ROA ratio might indicate that the company may be less effective in utilising its assets to generate earnings.

It is important to note that the ROA ratio will not tell you the actual size of net profit or the magnitude of assets. It’s just a utilisation ratio. 

The Return on Equity (ROE)

It measures a company's ability to provide returns to its shareholders. It shows how well equity has been utilised to generate profits. This is the ratio of net income to average total equity. 

Formula of Return on Equity:

ROE = Net income / average total equity 

Interpretation of the Return on Equity ratio: 

• A higher ratio indicates that a company effectively uses its shareholder’s equity to generate profits for its shareholders. 
• Lower ROE consistently by a company should be a matter of concern, and you should dig deeper to find the reasons. 

A deeper analysis of ROE can be done through Du Pont analysis. In the next section, let’s see the components of this analysis. 

Where Can I Check ROE on Angel One?

In order to check ROE on Angel One, simply:
1. Click on the stock from the search bar or from the Watchlist.
2. Click on ‘Overview’ and thereafter, click on ‘Stock Details’.
3. Scroll down and you will find valuation ratios, including ROE.

DuPont Analysis 

The DuPont system of analysis is an approach that can be used to break down ROE and analyse it. It uses basic algebra to break down ROE into a function of different ratios so an analyst can see the impact of three factors - leverage, profit margins, and turnover on shareholder returns.

ROE = Net profit margin * Asset turnover * Financial leverage ratio 

If ROE is relatively low, this means that at least one of the following is true: 

• The company has a poor profit margin
• The company has a poor asset turnover
• The firm has too little leverage

Also, if the ROE is high, you can still perform a DuPont analysis to find reasons, especially if financial leverage is the major contributor to a high ROE. 

Numerical Example with Solution

In the above section of this chapter, we discussed various profitability ratios. Applying and analysing the ratios on a company's actual financial statements is equally important. For this chapter, and going further, we will be calculating and analysing the financial statements of XYZ Ltd. The financial statements of XYZ Ltd were discussed in detail in the financial statement chapters. The steps you need to follow to understand this section are simple:

Step 1 - Snapshots of the actual financial statements are provided below. These statements consist of the crucial financial statements of XYZ Ltd - Statement of profit and loss, balance sheet and cash flow statement. 

Step 2 - A table named ‘Data Extract’ is provided below the snapshot for easy understanding. This table will include all the important line items and related numerical data from the financial statements of XYZ Ltd, needed to calculate a particular category of the ratio, like in this chapter - profitability ratios. Note all the amounts are in ₹ crore.

Step 3 - The solutions table is provided below the data extract table. This table includes the value of all the ratios taught in a particular chapter. However, you are expected to calculate the ratio value by yourself and then match your answers with the solution table to understand the concept better.

Step 4 - The analysis and interpretation section is provided towards the end. This includes the analysis of XYZ Ltd based on ratios calculated. 

Let’s start with the exercise:

Financial statements of XYZ Ltd 

Data extract:

Extract of data needed for profitability ratios
	[Amount in ₹ crore]	[Amount in ₹ crore]
Particulars	March 2023	March 2022
Revenue from operations	11,529	10,888
Net income	1,701	1,742
Cost of goods sold [COGS]	6,267.21	5,640
Gross profit (Revenue from operating - COGS)	5,261.79	5,248
EBIT (Operating profit)	2,296	2,307
Average total assets	12,969
Average total equity	8,931

Solution:

Value of profitability ratios:
Net profit margin	14.75%
Gross profit margin	45.64%
Operating profit margin	19.91%
Return on assets	13.12%
Return on equity	19.05%
For Du Pont Analysis
Net profit margin	14.75%
Asset turnover ratio	0.89
Financial leverage	1.45213302
ROE using DuPont	19.05%

Analysis and Interpretation 

• From the above solutions table, you can see that the margin is in double digits for XYZ Ltd. 
  The Company is profitable at various profitability metrics, i.e. gross, operating and net levels. Gross margins are around 45%, which tells you that the company’s cost of goods sold is around 55% of the revenue. Compare this with the peer as well as XYZ’s historical value.
• Even the operating margin is a decent 20%. This means for every ₹100 revenue, the company earns ₹20 after deducting all the operating expenses. You can dig deeper to analyse the most prominent operating expense and whether that expense can be reduced going forward.
• The ultimate bottom line margin, i.e. net profit margin, is 14.75%. This means for every ₹100 revenue, ₹14.75 remains with the company after meeting all its expenses and taxes. Once again, it's ideal to compare this with the peer and XYZ’s historical value.
• Returns on assets is 13%. This means for every ₹100 worth of assets, ₹13 is earned.
• Returns on equity is broadly 20%, which is considered the ideal return by investors. This is a measure of return to shareholders.
• The cross-verification of this value is done through Du Pont analysis to see the breakdown of ROE. This analysis shows that there is scope for XYZ Ltd to increase the ROE further by improving its asset turnover ratio, as the value is below 1. As the company's solvency is also strong, as analysed in the solvency ratios chapter, if XYZ borrows money going forward, there is scope to increase ROE further as the financial leverage increases, keeping other factors constant. Comparison with its historical value of ratios and peer comparison is equally important to conclude the findings. 

So, this was all about the profitability ratios chapter. In the next chapter, we will cover the last category of ratios that the investor community is usually excited about - Valuation ratios!