Profitability Ratio: Meaning, Formula, Types & Calculation

While choosing the right stock, profitability ratios are a crucial tool in fundamental analysis. These ratios are among the easiest methods to assess a company’s strength. They enable you to observe how effectively a company converts sales into actual profit.

For instance, the global profit margin of the leading retailer brand Walmart for the fiscal year 2025 was 24.1%. This can help investors determine why Walmart is ahead of its competitors in the global fast-moving consumer goods market.

This blog explains the profitability ratio meaning, different types of ratios and their calculation.

What are Profitability Ratios?

Profitability ratios are financial ratios which help to assess a company’s capacity to generate profit in contrast to sales, balance sheet assets, operational expenses, and shareholders’ equity over a certain time period. These ratios demonstrate how well a business makes use of its resources to generate revenue and value for investors.

Most businesses strive for a larger ratio or value since it often indicates that the company is doing well in terms of generating sales, profitability, and cash flow. When you use the ratios compared to businesses or historical times, they are most helpful.

There are primarily 2 types of profitability ratios, the margin ratio and return ratio.

Importance of Profitability Ratios

Profitability ratios help you analyse a company’s financial health and operational performance. Here are the reasons why these are useful both for you and the company itself:

1. Exposing Business Problems

Profitability ratios might reveal more about a company’s operations than financial statements do. Companies might find hidden problems that might otherwise go unreported by studying these indicators. For instance, a company that appears to be prosperous may be hiding inefficiencies in particular divisions or product categories.

2. Dealing With Seasonality

Profitability ratios are especially useful for companies that experience seasonal changes. As a result, companies may learn about peak and off-peak seasons by monitoring performance throughout predetermined time periods. This information may help with marketing plans, resource allocation, and budgetary decisions. This ensures that resources are maximised to take advantage of profitable times.

3. Drawing Investors’ Attention

High profitability ratios are an effective way to draw in investors. They show a company’s capacity for expansion and financial stability. Companies that consistently turn a profit are more likely to attract investors because they provide a strong basis for future success.

4. Making Comparative Analysis Easier

A key component of strategic planning is comparing a company’s performance to rivals or industry benchmarks. Profitability ratios give a more complete perspective, although revenue comparisons can give a broad overview. Companies may precisely evaluate their efficiency and find out opportunities for improvement by considering factors like profit margins and return on investment.

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Different Types of Profitability Ratios and Their Calculations  

There are numerous profitability ratios categorised under the margin ratios and return ratios. Some of the margin ratios are explained below, along with calculations:

1. Gross Profit Margin

A gross profit margin ratio measures how well a business controls its manufacturing expenses. As you discover the company’s pricing strength, this ratio becomes crucial.

The company’s cost of items supplied rises under inflationary pressure because of higher input costs. If a business can sustain its gross profit margins in such an inflationary climate, it has strong pricing power. This is because the business was able to effectively transfer the price rise to its customers.

The formula of gross profit margin is:

Gross Profit Margin = Gross Profit/Sales

2. Net Profit Margin

A net profit margin is one of the most popular profitability ratios that determines a company’s capacity to make money after its expenses. It divides a company’s net income by its total revenue.

After all costs, including interest and taxes, have been deducted, it presents the ultimate image of a company’s profitability. Since it accounts for everything, the net profit margin is a useful indicator of profitability.

However, one big flaw of this ratio is that it contains a lot of ‘noise’. This makes it more difficult to compare a company’s performance to that of its competitors.

Here is the formula for calculating net profit margin:

Net Profit Margin = Net Profit/Net Sales

3. Operating Profit Margin

An operating profit margin is the proportion of revenue that remains after deducting the cost of goods sold and regular operating costs. This ratio compares the operating profit and sales of a company.

A company’s operating margin might reveal how well it runs its business and how successfully managers control expenses and optimise profits. A company may be better able to manage its fixed costs and interest on liabilities if its operating margin is larger than that of its competitors. It can probably charge less than its competitors.

The formula for the operating profit margin ratio is:

Operating Profit Margin = Operating Profit/Net Sales

4. EBITDA Margin

EBITDA margin refers to earnings before interest, taxes, depreciation, and amortisation, in contrast to total revenue. Being one of the crucial profitability ratios, it shows a company’s profitability before accounting for non-cash expenses like depreciation and amortisation, as well as non-operating charges like taxes and interest.

Analysing a company’s EBITDA margin has the advantage of making it simple to compare it to other businesses since it eliminates costs that might be a little bit discretionary. The limitation of EBITDA margin is that it might differ significantly from real cash flow creation and net profit, which are more accurate measures of business performance.

The formula of EBITDA margin is:

EBITDA Margin = Net Profit + Interest + Taxes + Depreciation + Amortisation/Total Revenue

Now, let us understand some return ratios and their formula:

5. Return on Equity

The return on equity (ROE) is a crucial ratio as it measures a company’s capacity to generate a return on its equity investments. Without more equity investments, an ROE may increase, since it is determined by dividing net income by shareholders’ equity. Higher net income from a greater asset base financed by debt may cause the ratio to increase.

You may find a company appealing if it has a high ROE. It may show that a company can make money without using debt.

The formula of ROE is:

ROE = Net Profit/Shareholders’ Equity

6. Return on Assets

Return on assets (ROA) displays the proportion of net earnings to the total assets of the business. The ROA ratio shows how much profit a business makes after taxes for each INR of assets it owns. It also measures a company’s asset intensity. A company is said to be more asset-intensive if its profit per INR of assets is lower.

Large investments are necessary for highly asset-intensive companies to buy machinery and equipment to make money. Railroads, automakers, and telecommunications services are a few examples of companies that are frequently highly asset-intensive.

Here is the formula for ROA:

ROA = Net profit/Total assets

7. Return on Capital Employed

This return ratio shows how successfully a company uses its money from all sources to provide a return for those investors. Since it takes into account all of the capital that the company uses to generate profits rather than simply shareholder equity, it is considered a more sophisticated indicator than ROE. Return on capital employed (ROCE) compares after-tax operational profit with total capital employed. You can employ it internally to evaluate the proper use of capital.

Below is the formula for ROCE:

ROCE = EBIT/Capital Employed

How Can You Use Profitability Ratios?

Now that you have understood the profitability ratio formula, you should know how to use these ratios. Let us understand with an example. With a total equity capital of INR 10 crore, company X Ltd. is a firm that manufactures road bicycles.

There were INR 6 lakh in current liabilities and INR 40 lakh in total assets at the end of the fiscal year. The following is the income statement:

Operating Profit = Gross Profit – Operating Expenses – Depreciation

Operating Profit = 2,80,000 – 1,00,000 – 30,000 = INR 1,50,000

Based on the particulars of this table, you can use the above-mentioned 7 profitability ratios in the following manner:

What do Profitability Ratios Signal?

Profitability ratios highlight a company’s financial health and its operational effectiveness. As an investor, you can use them, along with other ratios, to determine whether you should buy a stock or not. Companies with higher profitability ratios define their strengths.

These profitability ratios are most useful when compared with similar companies and the company’s own performance history. In general, a higher profitability ratio relative to its historic values shows that the company is ahead of its competitors, and you can buy its stock.

Limitations of Using Profitability Ratios

Although profitability ratios help you a lot while making the right choice to buy a stock, they also have some limitations. Some of them are:

1. Short-Term Focus

Profitability ratios highlight recent financial results, which may miss out long-term trends, growth prospects, or the influence of upcoming policy changes. Consequently, these ratios cannot analyse the broader financial picture of a company.

2. Limited Scope

Profitability ratios use the debit and credit of funds to generate results, but often overlook what the underlying components denote. You may see a favourable high profit ratio, but without analysing the cost structure, market trends, and pricing strategy, this insight becomes useless.

3. Sector-Specific Nature

Different sectors have different profitability benchmarks. For example, an information technology company has higher profit margins compared to a steel manufacturer because of lower operational expenses. Hence, comparing profitability ratios across sectors is not meaningful, and you should analyse these ratios in the same sector.

4. Accounting Manipulation

Profitability ratios can be impacted by accounting practices. For instance, companies might change expenses according to their inventory valuation techniques. In addition, some companies may also delay expense reporting to boost ratios. Hence, you should evaluate the company’s accounting policies carefully.

Final Thought

With profitability ratios, you can choose stocks on your own by assessing a company’s financial health. They help you to analyse a company’s ability to produce income in contrast to its costs. Additionally, they also measure how effectively a company uses investments to produce returns for its shareholders.

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Frequently Asked Questions

1. What are the 5 profitability ratios you can use?

Although there are numerous profitability ratios, the net profit margin, gross profit margin, ROA, ROE, and operating profit margin are considered the most effective.

2. What is an appropriate profitability ratio?

An appropriate profitability ratio is more than 1.5% and the industry average of most countries in the world is closer to 2%.

3. How to calculate profitability ratios?

To calculate the profitability ratios, you need to divide the respective profit metric by net revenue.

4. Why are profitability ratios important?

The profitability ratios help you to assess a company’s capability to produce returns relative to its assets, revenue, and equity.