The ratio used to compare the companies within the same industry upon their profit margin Is profitability ratio. These ratios were helpful in assessing the company’s ability to generate profit through its earning without including the expenses. More profit is a shorter time is best among all.
The company had higher profitability ratio than the compared company comes out as a better company in generating profit. This ratio analysis can be done on the company’s previous and latest profit statements as well.
Some industries are seasonal based and made more profit at its specific season. For example, a company might earn more on Christmas as compared to other months. For such industries, it is not a good practice to compare the profits of the start of the month with the end of the month. The profitability ratio will be more useful if the comparison has been made upon the profit made in recent year season and profit made on the previous year season.
The profitability ratio will be more effective if the comparison has been made upon the profit made in recent year season and profit made on the previous year season.
Profitability ratio helps in calculating the company’s performance and its overall efficiency. This profitability ratio is divided into two: Margins, that represents the ability of the firm of translating dollar into profit and Return represents the ability of the firm to produce returns for its shareholders.
There are two types of profitability ratios. One is based on sales, and the other builds on investments. We will discuss both of them here.
Based on Sales:
Profitability ratio can be calculated by calculating the firm’s profit margin. Profit margin is the profit which company earns on every dollar of sales of the enterprise. Higher the profit margin, higher is the profit earned by the corporation. There can be different types of profit margins such as gross profit, net profit, and operating margin. It helps in calculating the profitability of a company.
Gross margin figures that how much company can buy sale after reaching the cost of goods sold. Operating margins estimates the expenses on operations while net profit is the profit that company earns after paying all the taxes. Therefore, these terms are essential when calculating the profitability ratio.
Based on investments:
ROE (Return on Equity):
Profitability ratio is also dependent on the returns that company gets on its equity. ROE measures the ability to revenue of the company through its investment in capital. ROE can increase very rapidly without further investing upon it, and it earns more for the enterprise. If a company increases its asset size the return on equity increases and equity holders gets more performance which grows with time.
ROA (Return on Asset):
The assessment of a company’s profitability is highly relative to its expense and cost. And profitability ratio is analyzed by comparing the assets that how a company is deploying its assets to generate more profit. The more assets a company acquires, the more profit it will get.
Now we will discuss some of the advantages and disadvantages of profitability ratio.
Advantages of profitability ratio:
Profitability ratio is simple and very easy to understand. The ratio helps in indicating the company that is more profitable and has more profit income as compared to other. It knows the importance of time while generating profit. The ratio helps in analyzing the stats that which company is making more profit in less time. It calculates the rate of return and hence making a group comparable to other and even with its past.
Disadvantages of profitability ratio:
It uses the cost used on the product and profit gain from it which might not be a real trick to compare companies as many other constraints are better to be considered when comparing.