PROFITABILITY REASONS: CHARACTERISTICS, WHAT IT IS FOR, EXAMPLES - DUDAS - 2025

The profitability ratios are financial metrics used to assess the ability of a company to produce profits in relation to their income, operating costs, assets of the balance sheet and shareholder equity, using data from a specific point in time.

A business exists primarily to add value. Of course, a business has dozens of other identities: it could be an employer, taxpayer, owner of intellectual property, or a corporation bent on doing environmental or social good.

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However, a company is still a system. It is an economic machine that combines a set of inputs with the aim of producing a result, a value, the sum of which is greater than the parts. This value is measured as profitability. It is literally the most important concept an investor has to understand.

Businesses typically look for the highest profitability ratio, as this generally means that the business is doing well in generating revenue, profit, and cash flow.

characteristics

Profitability ratios are the most popular indicators used in financial analysis. They are generally divided into two categories: margin ratios and return ratios.

Margin reasons

They allow to know, from several different angles, the ability of a company to convert sales into profits. These reasons are found exclusively in the income statement.

Gross profit margin

Conceptually, the following sequence is assumed: first, the company receives sales revenue. Then the expenses related directly to the manufacture of the product, such as raw materials, labor, etc. are subtracted.

These expenses are grouped as cost of merchandise sold in the income statement. What remains is gross profitability.

Gross profit margin = gross profit / sales income.

Operating profit margin

Indirect expenses such as rent, advertising, accounting, etc. are paid. By subtracting selling, general, and administrative expenses from the company's gross profitability, you get operating profitability.

Operating Profitability Margin = Operating Profitability / Sales Income.

Profitability margin before taxes

Interest is paid on the debt and any unusual income or charges not related to the company's main business are added or subtracted, thus leaving the profitability before taxes.

Profitability margin before taxes = profitability before taxes / sales income.

Net profit margin

Finally, taxes are paid, leaving a net profitability, which will be the final result.

Net Profitability Margin = Net Profitability / Sales Income.

Reasons for return

These ratios offer several ways to examine how well a company generates a return for its shareholders.

Return on assets

Profitability is analyzed against assets to see how effective a company is in using its assets to generate sales and, eventually, profits.

Return in this ratio refers to net profitability, which is the amount of profit on sales after subtracting all costs, expenses, and taxes.

As economies of scale help lower costs and improve margins, profitability can grow at a faster rate than assets, ultimately increasing return on assets.

Return on equity (ROE)

This ratio is the one that affects the shareholders of a company the most, as it measures the ability to obtain a return on capital investments.

As a company increases the amount of its assets and generates a better return with higher margins, shareholders can retain much of the growth in profitability when these additional assets are the result of obtaining debt.

What are they for

For most profitability reasons, having a higher value relative to a competitor's ratio or relative to the same ratio from a prior period indicates that the company is performing well.

Ratios are most informative and useful when used to compare a company to similar companies, to the company's own track record, or to average ratios for the industry as a whole.

Expense management

These ratios also indirectly measure how well a business manages its expenses relative to its net sales. That is why companies strive for higher ratios.

This can be done either by generating more income in order to keep expenses constant, or by keeping sales constant and reducing expenses.

Since generating additional income is much more difficult most of the time than cutting expenses, managers generally tend to cut spending budgets in order to improve their profitability ratios.

Measure effectiveness

Creditors and investors use these ratios to measure how effectively a business can convert sales to profitability.

Investors want to make sure profits are high enough to distribute dividends, while creditors want to make sure the company has enough profits to pay off its loans.

In other words, external users want to know that the company is operating efficiently.

An extremely low profitability ratio would indicate that expenses are too high and that management needs to budget and cut expenses.

Examples

Example 1

The company ABC International obtained a net profitability after taxes of $ 50,000, on net sales of $ 1,000,000. The profit ratio or net profit margin is:

$ 50,000 of profitability / $ 1,000,000 of sales = 5% Profitability ratio.

The net profit margin ratio is typically used on a monthly basis when performing a month-to-month comparison, as well as for year-to-date and year-to-date income statement results.

Example 2

Alaska Shop is an outdoor fishing store that sells lures and other fishing equipment to the public. Last year, Trisha had the best sales year she's had since opening the business 10 years ago. Last year, net sales were $ 1,000,000 and her net profitability was $ 100,000.

Here is Trisha's sales profitability ratio calculation: $ 100,000 / $ 1,000,000 = 10%.

As you can see, Alaska only converted 10% of its sales into profit. You can compare this ratio with this year's figures of $ 800,000 in net sales and $ 200,000 in net profitability.

This year, Alaska could have made fewer sales, but you can see that it cut expenses sharply and thus was able to convert more of these sales into profitability, with a ratio of 25%.

References

1. James Early (2019). Profitability Indicator Ratios: Profit Margin Analysis. Taken from: investopedia.com.
2. Steven Bragg (2018). Profit ratio - Profit margin ratio. Accounting Tools. Taken from: accountingtools.com.
3. My Accounting Course (2019). Profit Margin Ratio. Taken from: myaccountingcourse.com.
4. Will Kenton (2019). Profitability Ratios Definition. Taken from: investopedia.com.
5. CFI (2019). Profitability Ratios. Taken from: corporatefinanceinstitute.com.