What is Profitability Ratios?
Profitability ratios helps in determining and evaluating the ability of the company to generate the income against the expenses in incurs and takes into account the different elements of Balance Sheet and Profit and loss account of the company for analyzing the performance of the company.
List of Profitability Ratios Formulas
There are different types of profitability ratios that are being used by companies in order to track their operating performance. However, in this article, we will be discussing those which are based on margin. Three major ratios in this list are gross profit marginGross Profit MarginGross Profit Margin is the ratio that calculates the profitability of the company after deducting the direct cost of goods sold from the revenue and is expressed as a percentage of sales. It doesn’t include any other expenses into account except the cost of goods sold., net profit marginNet Profit MarginNet profit margin is the percentage of net income a company derives from its net sales. It indicates the organization's overall profitability after incurring its interest and tax expenses., and EBITDA marginEBITDA MarginEBITDA Margin is an operating profitability ratio that helps all stakeholders of the company get a clear picture of the company's operating profitability and cash flow position. It is calculated by dividing the company's earnings before interest, taxes, depreciation, and amortization (EBITDA) by its net revenue. EBITDA Margin = EBITDA / Net Sales, which we will be covered here.
#1 – Gross Profit Margin Ratio
The gross profit is calculated by deducting all the direct expenses called cost of goods soldCalled Cost Of Goods SoldThe Cost of Goods Sold (COGS) is the cumulative total of direct costs incurred for the goods or services sold, including direct expenses like raw material, direct labour cost and other direct costs. However, it excludes all the indirect expenses incurred by the company. from the sales revenue. The cost of goods sold primarily includes the cost of raw material and the labor expense incurred towards the production. Finally, the gross profit margin is calculated by dividing the gross profit by the sales revenue and is expressed in terms of percentage.
Below is the formula to calculate this Profitability Ratio.
#2 – Net Profit Margin Ratio
The net profit, which is also called profit after tax (PATPATProfit After Tax is the revenue left after deducting the business expenses and tax liabilities. This profit is reflected in the Profit & Loss statement of the business.), is calculated by deducting all the direct and indirect expenses from the sales revenue. Then, the net profit margin is calculated by dividing the net profit by the sales revenue and is expressed in terms of percentage.
Below is the formula to calculate this Profitability Ratio
#3 – EBITDA Margin Ratio
The EBITDA is calculated by adding back interest expense, taxes, depreciation & amortization expense to net profit or PAT. Then, the EBITDA margin is calculated by dividing the EBITDA by the sales revenue and is expressed in terms of percentage.
Explanation of the Profitability Ratios Analysis
#1 – How to Calculate Gross Profit Margin?
The formula for gross profit margin can be calculated by using the following steps:
- Step #1: Firstly, the sales revenueSales RevenueSales revenue refers to the income generated by any business entity by selling its goods or providing its services during the normal course of its operations. It is reported annually, quarterly or monthly as the case may be in the business entity's income statement/profit & loss account. is taken from the profit and loss account.
- Step #2: Then, the cost of goods sold is calculated, which is the summation of raw material consumed, labor expense, and other similar direct expenseDirect ExpenseDirect costs are costs incurred by an organization while performing its core business activity and can be attributed directly in the production cost, such as raw material costs, wages paid to factory staff, power & fuel expenses in a factory, and so on, but do not include indirect costs such as advertisement costs, administrative costs, etc. attributable to the manufacturing of the product. All the information is easily available from the profit and loss account.
- Cost of Goods Sold = Raw Material Cost + Labor Expense + Other Direct Expense
- Step #3: Now, the gross profit is calculated by deducting the cost of goods sold from the sales revenue.
- Step #4: Finally, the gross profit margin is calculated by dividing the gross profit by the sales revenue and multiplied by 100%.
- Gross Profit Margin = (Revenue – Cost of Goods Sold) / Revenue * 100%
#2 – How to Calculate Net Profit Margin?
The formula for Net Profit Margin can be calculated by using the following steps:
- Step #1: Firstly, the sales revenue is calculated as described above.
- Step #2: Then, the net profit (PAT) is captured, which is categorically mentioned as a separate line item in the profit and loss account.
- Step #3: Finally, the net profit margin is calculated by dividing the net profit (PAT) by the sales revenue and multiplied by 100%.
- Net Profit Margin = PAT / Revenue * 100%
#3 – How to Calculate EBITDA Margin?
EBITDA Margin formulaEBITDA Margin FormulaEBITDA Margin is an operating profitability ratio that helps all stakeholders of the company get a clear picture of the company's operating profitability and cash flow position. It is calculated by dividing the company's earnings before interest, taxes, depreciation, and amortization (EBITDA) by its net revenue. EBITDA Margin = EBITDA / Net Sales is given below. It can be calculated by using the following steps:
Following are the steps for calculation of EBITDA Margin –
- Firstly, the sales revenue is calculated as described above.
- Now, interest expense, depreciation amortization expense, and taxes paid are taken from the profit and loss account.
- Then, EBITDA is calculated by adding back interest expense, depreciation amortization expense, and taxes paid to PAT.
EBITDA = PAT + Interest + Taxes + Dep Amort
- Finally, the EBITDA margin is calculated by dividing the EBITDA by the sales revenue and multiplied by 100%.
EBITDA Margin = EBITDA / Revenue * 100%
Calculation Examples of Profitability Ratios Analysis
Below we have taken some practical examples to understand this concept.
Let us consider an example to calculate the profitability ratios for a company called XYZ Limited. XYZ Limited is in the business of manufacturing customized roller skates for both professional and amateur skaters. At the end of the financial year, XYZ Limited has earned $150,000 in total net sales along with the following expenses.
In the below template is the data for the calculation-
From the given information,
#1 – Gross profit
= Net sales – Cost of goods sold
So form the above calculation, gross profit will be:
#2 – Net profit = $31,000
#3 – EBITDA
= Net profit + Interest expense + Tax + Depreciation expense
So from the above calculation, EBITDA will be:
Now, the Profitability Ratios,
- Gross profit margin
- = Gross profit / Net sales * 100
- Net Profit margin,
- = Net profit / Net sales*100%
- EBITDA margin
- = EBITDA / Net sales*100%
Profitability Ratio Analysis in Excel
Now let us take the real-life example of Apple Inc. to illustrate the different profitability ratios in the excel template below. The table provides the detailed calculation using different profitability ratio formulas
We note the following about the profitability ratios of Apple
- Net Profit Margin has increased from 21.19% in 2016 to 22.41% in 2018
- Gross profit margin, on the other hand, has decreased from 39.08% to 38.34%
- Likewise, the EBITDA margin has decreased from 34.01% to 32.77%
Relevance and Use
- Profitability ratios are basically used to assess how a company is performing, which is measured by calculating profitabilityCalculating ProfitabilityProfitability refers to a company's ability to generate revenue and maximize profit above its expenditure and operational costs. It is measured using specific ratios such as gross profit margin, EBITDA, and net profit margin. It aids investors in analyzing the company's performance. at different levels, i.e., Gross, PAT, and EBITDA.
- These ratios show the percentage of sales that are absorbed by the operating expense at different levels. Hence, the lower the operating expense ratioOperating Expense RatioOperating Expense Ratio is the ratio between the cost of operation to the net revenue and is commonly used to evaluate real estate properties. A higher Operating Expense ratio indicates that the company's operating expenses are higher than its property income, which acts as a deterrent. A lower operating expense ratio implies lower operating costs, which is preferred and investment-friendly., the higher will be the profitability, which will indicate better performance.
- However, there remains a limitation of the profitability ratio as it is useful only when comparing companies in the same industry.
Profitability Ratios Formula Video
This article has been a guide to Profitability Ratios Analysis and its definition. Here we discuss the formula to calculate Profitability Ratios (Gross Margin, Net Margin, EBITDA Margin) using practical examples and a downloadable excel template. You can learn more about financial analysis from the following articles –