Analysts and investors use profitability ratios to measure and evaluate a company's ability to create income (profit) in relation to revenue, balance sheet assets, operating costs, and shareholders' equity.
Today, we will look at some of the widely used profitability ratios.
Gross Profit Margin is a measurement of sales profit. After deducting the costs of items sold, it represents the profit portion of the total revenue collected. It is critical since the gross profit is what pays for administrative and office expenses and dividends to shareholders. The bigger the gross profit, the more profitable the business is and the better the investment opportunity. It is also used to evaluate the efficiency of cost management, as mentioned previously. If the computation indicates that the ratio is currently, the primary areas to examine or improve in terms of economy and effectiveness are purchasing and output.
Gross Profit Margin = ((Revenue – Cost ofGoods Sold)/Revenue) *100
Net Profit Margin is the final ratio that shows a company's total success. We may argue that it is the most crucial ratio for management because any changes in other ratios indirectly impact the net profit margin. A low quick ratio, for example, could indicate poor sales, which would imply a reduced net profit margin. This ratio is significant because it can assist the company or investors determine where current operating expenses may be going awry. The interest costs are too high due to the financing strategy, which favors loans over equity.
Net Profit Margin = ((Revenue – Total Cost)/Revenue) *100
Returns on equity are among the most important ratios for investors, while the net profit margin is an essential indicator for the organization. It is a percentage of the profits received by shareholders in exchange for their investment in the company. The greater the ROE, the bigger the dividends paid to shareholders, and more investors are drawn in.
ROE = (Net Income/Shareholder's Equity)
The efficiency with which a corporation utilizes its assets is measured by its return on capital employed (ROCE). Measuring the ROCE assists management in reducing inefficiencies. The higher the ROCE compared to other industries; the more efficient the company's production process is.
ROCE = Earnings Before Interest and Tax/Capital Employed
Return on assets (ROA) measures how much money a company makes on every dollar of assets it owns. It's similar to the ROCE and aids management in asset utilization management.
ROA = Net Income/Total Assets
The profitability of companies varies from sector to sector; while comparing different companies using profitability ratios, we need to consider companies from the same sector only.
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