Profitability Ratios Definition – Meaning and Examples

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profitability ratios definition

Profitability Ratios Definition

Profitability Ratios Definition – “Measures of a company’s level of profitability, in which profits are expressed as a percentage of various other items”.

In simple words, these are the ratio which reflects the extent of returns in the company’s inventory or other assets. The main purpose of calculating profitability ratio is to know how efficient the company in making the profits from capital or assets.

In addition to this, these ratios also shows whether the companies assets are making operational profit or not. This concept is also vital for solvency and going concern concept of accounting principles.

Profitability Ratios Examples

In order to understand Profitability ratios definition, lets have a look over different types of profitability ratios that are given below –

Gross Margin Ratio

One of the profitability ratio which is the ratio of gross margin to the net sales of the business. This ratio shows company’s efficiency in clearing its inventory. Do not confuse gross margin with profit margin. Both are different. The gross margin considers the cost of goods sold in its calculation. As it involves the measurement of organization’s efficiency in selling the inventory.

Formula

Gross Margin Ratio = Gross Margin/ Net Sales

where, gross margin = Net sales – Cost of goods sold

Profit Margin Ratio

It refers to the total net profit earned from the revenues collected by the organization. In simple words, it means the revenue left after providing for all the expenses. Investors use this ratio in order to see how efficient the company is in converting sales into net income and in cost cutting.

Formula

Profit Margin Ratio = Net Income/ Net Sales

Return on Assets

It is also known as ROA. It is the ratio of Returns to the total assets. In simple words this ratio shows how much income the organization has earned using the assets available to it. So, this ratio measures the efficiency of the company of utilizing the assets in such a manner that it results in earning of a certain amount of income during a certain period of time.

Formula

ROA = Net Assets/ Average total assets

Here, Average total assets = (Assets in the beginning of the year + Assets at the end of year)/2

Return on Capital Employed

It refers to the efficiency of the company to generate the profits from the capital employed by it. In simple words, it is the ratio of net operating profit with respect to the capital employed. It is one of the long term profitability ratio that reflects how effective are company’s assets in terms of the long term financing.

ROCE = Net operating profit/ Capital Employed

Capital Employed = Total Assets – Current Liabilities

Return on Equity

It refers to the ability of company to make profits from the shareholders investments. In simple words, this ratio shows the how much profit each rupee of shareholder investment generates. It is knows as ROE and shows how efficient the organization is using its equity financing.

Formula

Return on Equity = Net Income/ Shareholder’s Equity

Related Financial Terms of Profitability Ratios

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