Profitability Ratio

How much profit an organisation generates only has meaning when profit is compared with the money that was used to create that profit. Profitability is ultimately the ability of an entity to receive a return on investment. If an entity is not profitable, it may be better to invest the money elsewhere.

Profitability ratios will answer the questions:

• What is the return on the assets used by the organisation?
• What is the return on the owner’s investment in the organisation?
• Did our business maintain mark-ups as planned?
• Does our business have good control over expenses?

The main profitability ratios include the return on assets ratio and the return on equity ratio.

Another aspect of profitability is the percentage of profit that is squeezed from sales. These ratios include mark-up percentage, gross margin and net margin.

Return on Assets

Return on assets = Profit before interest and tax x 100 (Total assets)

How to interpret this ratio: Profit is earned by using assets (for example, the use of property, equipment and inventory necessary to run the business. This ratio measures the profit or return on investment made in assets. A low return could suggest that there are perhaps assets that need to be disposed of. The return on assets calculation is a return on investment calculation that the managers of the business would be interested in.

Return on Equity

Return on equity = Profit after tax and preference dividend x 100 (Equity)

How to interpret this ratio: This ratio measures also measures a return on investment, but the investment is restricted to the investment of ordinary shareholders (i.e. the equity). The return on equity is calculated after interest, tax and preference dividends have been taken into account. The return on equity calculation is a return on investment calculation from the shareholders point of view.

Mark-Up Percentage

Mark-up percentage = Gross Profit x 100 (Cost of Sales)

How to interpret this ratio: An organisation may price a product by adding a percentage to the cost of the product. Gross profit is the amount resulting from mark-ups on sold products. If the mark-up is very low, this could be an indication that products are being sold too cheaply. This ratio can also be used to ascertain if there was any increase in mark-ups from one period to the next.

Gross Margin

Gross margin = Gross Profit x 100 (Sales)

How to interpret this ratio:  Mark-ups may also be expressed as a percentage of the sales price as opposed to a percentage of the cost as in the previous ratio. The mark-up percentage ratio and gross margin ratio essentially measure the same thing.

Net Margin

Net margin = Profit after tax x 100 (Sales )

How to interpret this ratio: This shows the portion of profit made out of sales after expenses. A large net margin indicates a good expense control.

Click here to view a video that explains the Profitability Ratio.