What are profitability ratios?

What's the purpose of profitability ratios?

There are certain metrics that every would be investor needs to understand. Profitability ratios are no exception. They indicate to the investor how efficient the business is at producing shareholder profits. The profits of the business can be spent in two main ways. One, to reinvest in the business in order to boost the future profitability of the business. Second, profits can be paid out to the ultimate owners of the business i.e. the shareholders also known as the investors.


Accounting assessment of profit 

Profitability ratios will indicate to the investor the amount of cash that can be paid out. There are various accounting rules that state that a company cannot pay out to shareholders in the form of dividend any more than they have earned in profits.

Profit as a measure of efficiency

Finally profit and consequently profitability ratios are an indicator as to how efficiently the business is being run. At the extreme end, negative profit, i.e. losses clearly suggest that that the business isn't doing very well. Comparing two different business in the same industry, it's likely to be the case that the business with the higher profitability ratio will be the better business.

Take for example a business that generates £100 profit off the back of £100,000 of sales versus a business that makes £100 profit off the back of £1,000 of sales. Which business would you rather have? Clearly the business that produces the profit from only one hundredth of the sales. Why? Because a lot less work needs to happen in the second business to produce the same amount of sales. You're looking for businesses that demonstrate efficiency in terms of producing profit. This is what profitability ratios are used for: gross profit margin, net profit margin, ROCE, and ROI.

Gross and net profit margin

Gross profit it calculated as the gross profit figure (sales minus the direct costs associated with producing those sales) divided by the total value of sales multiplied by 100. Or simply: gross profit / sales * 100.

The ratio tells you how good the business is at producing excess revenue from its sales in order to cover the costs that it has no control over such as rent or insurance (also called fixed costs). The gross margin is expressed as a percentage and tells you how good the business is at producing profit per individual sale ignoring all other fixed overheads.

Net profit margin is similar. To calculate it simply replace the "gross profit" figure in the above calculation with "net profit". Net profit is defined as the profit made by a business after considering all costs within a business ie the direct cost of sales and all of the fixed overheads and tax as well. It is the bottom line profit that can be paid out to shareholders. Net profit margin is therefore a measure of how efficient the business is at producing profit per £1 of sales.

In both cases you would want to invest in a company that can produce high gross profit margins and high net profit margins compared to its competition. It's useful to compare the two margins together as well. Net margin will virtually always be lower than gross margin as it takes all of the extra costs of running a business into account such as rent, administration costs, marketing costs and salaries. However, a company where the two margin figures are vastly different may indicate a business that is overspending in areas that do not directly relate to making sales to customers, indicating inefficiency,

Return on capital employed (ROCE)

Return on capital employed (ROCE) is a measure as to how good the business is at producing profit from all the invested money. Businesses are generally started in two/ three different ways - either they started by an individual or individuals investing their own cash into a business, or by borrowing money from a bank or another similar institution, or else some combination of the two sources of cash.

ROCE tests how efficiently those original cash sources are put to work. The calculation is: net profit divided by all of the debt and invested cash in the business. Simply: net profit / (debt plus equity). A higher ROCE indicates that a business has made good use of the funds within a business. You should be more inclined to invest in businesses that generate lots of profit from a relatively small amount of originally invested cash (from the investor and from a bank).

Return on Investment (ROI)

Finally, return on investment (ROI) is similar in nature to the ROCE except that this time we strip out the debt portion of the calculation. The measure asks the question, if you were to invest your cash, what is the likely return that you will achieve in terms of bottom line profit. The higher the ROI the more attractive is the business.

Readers, any more profitability ratios out there that are worth noting for potential investors?

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