Profitability ratio, Finance Basics

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Profitability Ratio

These ratios signify the performance of the firm in relation to its capability to derive returns or profit from investment or from sale of goods that is profit margin or sales.

Profitability in relation to sales

  1. The ratio indicates the ability of the firm to control its cost of sales, operating and financing expenses.
  2. They include:

a) Gross profit margin = (Gross profit/Sales) x 100

The ratio signify the ability of the firm to control cost of sales expenses as like gross profit margin of 40% means like 60% of sales revenue was taken up via cost of sales whereas 40% was the gross profit.

b) Operating profit margin = (Operating profit/Earnings before interest & tax)/Sales

The ratio signify capability of the firm to control its operating expenses that like distribution cost, wages and salaries, travelling, telephone and electricity charges etc. as a ratio of 20% means like:

i) 80% of sales relate to both cost and operating of sales expenses

ii) 20% of sales remained as operating margin profit

c) Net profit margin = (Net profit x 100 (earning after tax) + interest)/Sales

This ratio signify the capability of the firm to control financing expenses in particular interest charges e.g. Net profit margin of 10% signify that:

i) 90% of sales were taken up via cost of sales, financing and operating expenses

ii) 10% remained as net profits.


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