Profitability is entity’s ability to generate profit i.e. generating revenues (cash inflows from business activities) exceeding overall expenses (cash outflows related to business activities).
Profitability is one of the easiest ways to evaluate entity as profit directly affects shareholders’ wealth. As every shareholder desires wealth maximization, attempt to maximize profits makes sense as more profits translate to:
- more dividends i.e. share of profit given to shareholders
- more retained earnings i.e. share of profit retained by the entity which in simple words mean more money available to management for growth, reinvestment and expansion
- more dividends, retained earning and growth ultimately result in increased share value. More share value = more the value of business = more capital gain for shareholders.
In short, when entity makes profit, shareholders benefit from it and management tries to go to any length to put the biggest possible number on the income statement. Another reason why profit maximization is so important is that more profits mean entity generating cash inflow more than cash outflows which simply means more cash available to the entity and more cash strengthens entity’s liquidity and solvency position.
Profitability ratios analyse how successfully entity has generated favourable returns or earnings. This is done by comparing profit earned with different items of financial information. For example profit made for every dollar of revenue earned, every dollar invested in assets or each dollar of equity.
Broadly profitability ratios are subdivided in two categories:
- return on revenue: profitability ratios based on sales revenue of the entity
- return on capital: profitability ratios based on shared capital, equity or total assets
Following are common profitability ratios:
| Gross profit margin | = | Gross profit | / | Revenue |
| Operating profit margin | = | Operating profit | / | Revenue |
| Net profit margin | = | Net profit | / | Revenue |
| Return on assets | = | Relevant returns | / | Total assets |
| Return on capital employed | = | Earning before interest and tax | / | Equity + liabilities |
| Return on equity | = | Relevant returns | / | Average Equity |
| Return on ordinary shares | = | Profits available for ordinary shareholders | / | Average ordinary equity |
Few words on numerator and denominator of ratios
The term revenue is just another name of sales or turnover. The ratios that compare two income statement figures for example gross profit and revenue are more compatible as both figures are accounted for over the period of time. However, few ratios have denominator taken from statement of financial position that are figures at a specific date and for this reason they are taken on average basis i.e. average of start and end of the period. This way we can achieve considerable compatibility.
The term relevant returns simply means such profit that is most suitable and relevant for calculation in given circumstances. Relevant returns can be operating profits, profits before interest and tax (also known as earning before interest and tax [EBIT]) or profits available to ordinary and preference shareholders etc. Its up to management to decide which figure should be used for given ratio.