Define Profitability Ratio Analysis

What Is Profitability Ratio Analysis?

The profitability ratio analysis is a set of financial analysis metrics that are used to assess the financial capability of a business and to measure the ability of the business to generate earnings other than the expenses and the relevant costs incurred during a specific period of time. The profitability ratio analysis shows the company’s overall efficiency and performance.

On the other hand, the profitability analysis is one of the components of the enterprise resource planning (ERP) that is used to allow the administrators to determine the profitability of a proposal and increase or optimize the profitability of an existing project.

The Two Types of Profitability Ratios

The profitability ratio is divided into two types: margins and returns.

Margin Ratios

The margin ratio represents the company’s ability to translate the sales dollars into profits at various cost levels.

• Gross profit margin – The gross profit margin describes the cost of goods sold as a percentage of sales. This ratio measures the company’s ability to control the costs of its inventory, as well as the manufacturing of the product and passing the costs to the customer.
• Operating profit margin – The operating profit margin is also known as the EBIT (Earnings Before Interest and Taxes). The operating profit margin is found on the income statement of the company and measures the overall operating efficiency, the expenses and the daily activity of the business.
• Net profit margin – The net profit margin simply shows each sales analysis dollars that show up as net income after all expenses are paid.
• Cash flow margin – This ratio measures the ability of the company to turn sales into cash.

Returns Ratios

The return ratio shows the ability of the company to measure the overall efficiency in generating returns.

• Return on assets – Measures the efficiency in managing the investment of assets and using them to generate profit.
• Return on equity – Measures the return of money that the investors put in the company.

Uses and Limitations of Profitability Ratio Analysis

Uses

• Profitability ratio analysis helps the managers to analyze, control, and improve the company’s operation.
• Determine the company’s ability to pay its debts.
• Determine the company’s efficiency and growth prospects.

Limitations

• The profitability ratio analysis example is more useful to small and narrowly-focused business because large and multi divisional companies operate a large number of activities in different industries that it is more difficult to develop a set of industry averages for comparative purposes.
• Industry leader ratio must be used to attain a high-performance instead of profitability ratio.
• The inflation can badly change and affect the balance sheet of the company and thus also affect the profitability ratio.
• Seasonal factors such as the turnover ratio can also distort ratio analysis. But this can be controlled and reduce using monthly averages for inventory.
• The company that uses different accounting practices for inventory valuation and depreciation methods can change the comparisons.
• It is difficult to determine whether the profitability ratio is good or bad.
• The result of the profitability ratio may show ratios that are good and bad at the same time, making it difficult to determine whether the company is strong or weak in the current position.