Profitability refers to the financial performance of the business. Those ratios which measure a company’s ability to generate revenue compared to its expenses and other costs associated with generation of income during that period are called Profitability Ratios .
These ratios show how well a company is able to make profits from its operations.
These ratios are used by investors & creditors to determine useful insights about the financial performance & well being of the business.
TYPES OF PROFITABILITY RATIOS –
The profitability ratios are of following 8 types :
- RETURN ON EQUITY RATIO :- This ratio measures Profitability of equity fund invested the company. It is calculated as –
Return on Equity = Net Income ÷ Shareholder’s equity
A higher equity ratio is considered good as it indicates good performance of the company.
- EARNINGS PER SHARE OR EPS :- EPS is a profitability ratio that measures the extent to which a company earns profit. It is calculated as –
Earnings per share = Net Profit ÷ Total no. of shares outstanding
- GROSS PROFIT RATIO :- The gross profit ratio determines the percentage of disposable income available with the organization to carry out business operations.
Gross profit ratio = Gross Profit ÷ Sales × 100
A high ratio represents the greater profit margin and it’s good for the company.
- NET PROFIT RATIO :- Net Profit Ratio measures the relationship between Net Profit and Net Sales. It shows the percentage of Net Profit earned on Revenue from Operations.
Net profit ratio = Net Profit / Net Sales x 100
Net Profit = Revenue from Operations – Cost of Revenue from Operations – Operating Expenses – Non-operating Expenses + Non-operating Incomes – Tax
A high net profit ratio is favourable for the business as it indicates positive return in the company.
- RETURN ON ASSETS :- This ratio determines the company’s ability to earn a profit in comparison to the total assets employed in the business. It is calculated as –
Return on Asset = Net profit after taxes / Total Assets x 100
- RETURN ON CAPITAL EMPLOYED :- This ratio measures percentage return in the company on the funds invested in the business by its owners. It is calculated as –
Return on Capital Employed =
Net Operating Profit ÷ Capital Employed × 100
Capital Employed = Total Assets – Current Liability
- DIVIDEND PER SHARE :- It calculates the amount of money paid by a company to its shareholders. The formula is:-
Dividends per share =
Total amount distributed to shareholders ÷ Total number of shares outstanding
- PRICE EARNING RATIO :- Price Earnings Ratio( PE Ratio ) is the relationship between a company’s share price and earnings per share (EPS).It is calculated as –
Price Earning Ratio = Market Price of Share ÷ Earnings per share
This ratio shows if the company’s stock is overvalued or undervalued.
Thus, in simple words Profitability ratios are those accounting ratios which are used to measure the profitability of the business & show how well a company is able to make profits from its operations.