Profitability ratios are a type of accounting ratio that helps in determining the financial performance of a business at the end of an accounting period. Profitability ratios show how well a company is able to make profits from its operations.
Profitability ratios are used by investors and creditors to determine a company’s return on investment based on the resources available to the business. It can also be said that profitability ratios can be used to judge if the company is generating enough profit by utilizing its assets.
Let us now discuss about the types of profitability ratios
Types of Profitability Ratios
The following types of profitability ratios are there:
- Return on Equity
- Earnings Per Share
- Dividend Per Share
- Price Earnings Ratio
- Return on Capital Employed
- Return on Assets
- Gross Profit Ratio
- Net Profit Ratio
1. Return on Equity or ROE
Return on equity (ROE) is a profitability ratio that is used to measure the profitability that can be generated from the shareholders investments. It is an effective way of measuring the utilisation of owners funds to generate profits for the business in the form of revenue.
It is represented by the formula as
Return on Equity = Net Income ÷ Shareholder’s equity
A higher return on equity ratio is considered good from investors point of view as this ratio is used to calculate the money or profit that is generated from the investment done by owners.
2. Earnings per share or EPS
Earnings per share or EPS is a profitability ratio that measures the extent to which a company earns profit. It is calculated by dividing the net profit earned by outstanding shares.
The formula for calculating EPS is
Earnings per share = Net Profit ÷ Total no. of shares outstanding
Having higher EPS translates into more profitability for the company.
3. Dividend per share
Dividends per share is a profitability ratio that calculates the amount of money paid by a company to its shareholders. It is calculated by dividing the totals dividends paid to shareholders by the total number of shares outstanding.
It is represented as
Dividends per share = Total amount distributed to shareholders ÷ Total number of shares outstanding.
Dividends per share is an important ratio that is used by investors to determine the income earned by shareholders.
4. Price Earnings Ratio or Price to Earnings Ratio
This is also known as P/E Ratio. It establishes a relationship between the stock (share) price of a company and the earnings per share. It is very helpful for investors as they will be more interested in knowing the profitability of the shares of the company and how much profitable it will be in future.
P/E ratio is calculated as follows:
P/E Ratio = Market value per share ÷ Earnings per share
It shows if the company’s stock is overvalued or undervalued.
5. Return on Capital Employed
Return on capital employed or ROCE is a profitability ratio that measures how well a company is able to generate profits from its capital. It is an important ratio that is mostly used by investors while screening for companies to invest.
It is calculated by dividing the EBIT(Operating Income) with Capital employed
ROCE = EBIT ÷ Capital Employed
Where EBIT = Earnings before interest and taxes
Capital Employed = Total Assets – Current Liabilities
6. Return on Assets
Return on assets is a ratio that determines the efficiency of a company in managing its assets and generating profits during the period. It is calculated by dividing the net income with total assets.
Formula for Return on Assets is as follows
ROA = Net Income ÷ Total Assets
This ratio gives an idea to the investors about the efficiency of the company in converting the investments into net income.
7. Gross Profit Ratio
Gross Profit Ratio is a profitability ratio that measures the relationship between the gross profit and net sales revenue. When it is expressed as a percentage it is also known as the Gross Profit Margin.
Formula for Gross Profit ratio is
Gross Profit Ratio = Gross Profit ÷ Net Sales
A fluctuating gross profit ratio is indicative of inferior product or management practices.
8. Net Profit Ratio
Net profit ratio is an important profitability ratio that shows the relationship between net sales and net profit after tax. When expressed as percentage it is known as net profit margin.
Formula for net profit ratio is
Net Profit Ratio = Net Profit after tax ÷ Net sales
It helps investors in determining whether company’s management is able to generate profit from the sales and how well the operating costs and costs related to overhead are contained.
This concludes the topic on the profitability ratios. It will provide sufficient information to the students to form a clear idea about the profitability ratios. For more such in-depth concepts, stay tuned to BYJU’S.