Profitability ratios, as the name suggests, are a set of ratios that show how profitable a company’s business is. We measure them by calculating the profit that a firm makes on each rupee of sales or revenue it generates.
Commonly used ratios As there are different measures of profit (such as gross profit, operating profit and net profit), we can calculate one profitability ratio corresponding to each measure of profit. These ratios are gross profit margin (GPM), operating profit margin (OPM) and net profit margin (NPM).
Other indicators
Besides these commonly used ratios, there is another set of profitability ratios. These measure the profit earned by the company on each rupee of capital invested in it. These are return on capital, return on assets and return on equity. Here, however, we will discuss the first set of profitability ratios.
A Gross profit margin It is the ratio of gross profit (sales minus cost of sales) to sales. Consider a company with Rs 100 as sales and Rs 10 as cost of goods sold. The gross profit would be Rs 90
(Rs 100–Rs 10) and GPM would be 90 per cent (Rs 90/Rs 100). A higher GPM compared to others in the same industry indicates either or both of the two possibilities: higher realisation on each unit sold and the ability to source raw materials at a lower cost.
B Operating margin It shows the impact of operating cost on a company’s profitability, and is calculated as operating profit divided by sales. A high operating cost affects the OPM. In the above example, if the operating cost other than the cost of sales is Rs 50, the operating profit would be Rs 40 (Rs 90–Rs 50) and OPM would be 40 per cent. If OPM increases over time and GPM remains the same, it indicates improvement in operating efficiency.
C Net profit margin It shows how much a company saves after meeting all its expenses. So, an NPM of 20 per cent would mean that a company is able to save Rs 20 per Rs 100 sales after meeting all its expenses. If a company’s NPM increases over time and OPM remains the same, it indicates reduction in non-operating expenses such as taxes and the interest outgo.
Profitability ratios help you pick the best among various stocks. The higher the ratio, the better it is. However, ensure that the comparison is made among companies from the same sector as different industries have different levels of profitability.
Other indicators
Besides these commonly used ratios, there is another set of profitability ratios. These measure the profit earned by the company on each rupee of capital invested in it. These are return on capital, return on assets and return on equity. Here, however, we will discuss the first set of profitability ratios.
A Gross profit margin It is the ratio of gross profit (sales minus cost of sales) to sales. Consider a company with Rs 100 as sales and Rs 10 as cost of goods sold. The gross profit would be Rs 90
(Rs 100–Rs 10) and GPM would be 90 per cent (Rs 90/Rs 100). A higher GPM compared to others in the same industry indicates either or both of the two possibilities: higher realisation on each unit sold and the ability to source raw materials at a lower cost.
B Operating margin It shows the impact of operating cost on a company’s profitability, and is calculated as operating profit divided by sales. A high operating cost affects the OPM. In the above example, if the operating cost other than the cost of sales is Rs 50, the operating profit would be Rs 40 (Rs 90–Rs 50) and OPM would be 40 per cent. If OPM increases over time and GPM remains the same, it indicates improvement in operating efficiency.
C Net profit margin It shows how much a company saves after meeting all its expenses. So, an NPM of 20 per cent would mean that a company is able to save Rs 20 per Rs 100 sales after meeting all its expenses. If a company’s NPM increases over time and OPM remains the same, it indicates reduction in non-operating expenses such as taxes and the interest outgo.
Profitability ratios help you pick the best among various stocks. The higher the ratio, the better it is. However, ensure that the comparison is made among companies from the same sector as different industries have different levels of profitability.
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