Reviewing, assessing and comparing financial statements is a good way to analyse the financial performance of a business. However, for the analysis to be more valuable, it is useful to calculate and analyse the financial ratios. The most significant financial ratios are those that state the profitability of a business. Let's find out what profitability ratios are exactly.
Profitability ratio: Definition
To understand what profit ratios are, it is crucial to first understand what financial ratios are.
Financial ratios calculate and compare the relationship between two or more elements of financial data sourced from a business's financial statements such as income statements or balance sheets.
Example of a financial ratio:
Liquidity ratio, leverage ratio, efficiency ratio, profitability ratio, and market value ratio.
Although there are numerous financial ratios, the most significant ones are typically those that state the profitability of a business.
Profitability is the ability of a business to generate profits from its operations. It is measured using income and expenses.
Simply put, profitability refers to how a business makes money from what it does. It relates to how a business earns income considering its expenses.
Profit ratios compare a business’s profit to another figure from its financial statements. They typically compare profit to revenue earned.
Profitability Ratio: Gross profit and net profit
There are two profit figures that can be used to calculate profit ratios: gross profit and net profit.
If revenue is £100 and costs are £20, then the gross profit will equal £80.
Net profit is the profit made by a business after all of its expenses have been subtracted from revenues. These expenses include costs related to manufacturing and selling products, interest, taxes, and any other expenses.
If revenue is £100, costs £20, and tax £5, then the net profit will equal £75.
To sum up, gross profit includes costs related to manufacturing and selling products, whereas net profit includes all the expenses.
Gross profit and net profit figures can be found in the income statement.
Fig. 1 - An Increase in Profit
Types of profit ratios
There are two financial ratios that help analyse the profitability of a business: gross profit margin and net profit margin.
Fig. 2 - Calculating Profit
Profitability Ratio: Gross profit margin
The gross profit margin shows the amount of money leftover from product sales after subtracting the cost of goods sold (the amount the business spent on manufacturing the product).
The gross profit margin compares a business’s gross profit for a trading period with its revenue for the same year. It is expressed as a percentage. The higher the value, the more gross profit a firm is generating from its sales.
The formula for calculating gross profit margin is the following:
If gross profit is £110,000 and revenue is £100,000, then thegross profit margin will be 110%.
However, is 110% a good value for gross profit? It is hard to say by just looking at this one figure. To answer this question, one should compare the value with:
A business’s target for its gross profit margin
A business’s gross profit margin from previous years
The gross profit margin of other similar businesses.
Profitability Ratio: Net profit margin
The net profit margin shows how much net profit or income is generated as a percentage of revenue.
The net profit margin compares a business’s net profit for a trading period with the revenue for the same year. It is expressed as a percentage. The higher the value, the more net profit a business is generating from its sales.
The formula for calculating net profit margin is the following:
If net profit is £300,000 and revenue is £330,000, then net profit margin will be 91%.
It means that £0.91 in each £1 is net profit.
However, is 91% a good value for net profit? As with the gross profit margin, it is hard to say by just looking at this one figure. To answer this question, one should compare the value with:
A business’s target for its net profit margin
A business’s net profit margin from previous years
The net profit margin of other similar businesses.
In general, the net profit margin can be a better indicator of a business's financial performance in terms of profitability. This is because compared to gross profit margin, which includes a business’s costs of sales only, net profit margin includes all costs paid by a business.
Profit ratios - Key takeaways
- Financial ratios calculate and compare the relationship between two or more elements of financial data sourced from a business's financial statements, such as income statements or balance sheets.
- Profitability is the ability of a business to generate profits from its operations. It is measured using income and expenses.
- Profit ratios compare a business’s profit to another figure from its financial statements. They typically compare profit to revenue earned.
- Gross profit is the profit made by a business after subtracting all the costs related to manufacturing and selling its products.
- Net profit is the profit made by a business after all of its expenses have been subtracted from revenues. These expenses include costs related to manufacturing and selling products, interest, taxes, and any other expenses.
- There are two financial ratios that help analyse the profitability of a business: gross profit margin and net profit margin.
- The gross profit margin shows the amount of money left over from product sales after subtracting the cost of goods sold.
- The net profit margin shows how much net profit or income is generated as a percentage of revenue.
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