Profitability Ratios – A Level Business CAIE Revision

Introduction to Profitability Ratios

Profitability ratios are financial metrics that used to assess a business’s ability to generate earnings compared to its expenses and other relevant costs incurred during a specific period of time.
They provide an overview of the company’s profit making efficiency and are vital to shareholders, investors, and creditors for investment or lending decisions.

Gross Profit Margin: Calculates the company’s financial health and business model by revealing the proportion of money left from revenues after accounting for cost of goods sold (COGS). It is calculated as (Gross Profit/Sales) x 100.
Net Profit Margin: This ratio calculates the percentage of revenue that remains as net income, after all expenses are deducted. It is calculated as (Net Income/Revenues) x 100.
Return on Assets (ROA): The efficiency in managing assets to generate profits is measured by the return on assets ratio. It’s computed as (Net Income/Total Assets) x 100.
Return on Equity (ROE): It measures the financial performance by identifying how much profit a company generates with the money shareholders have invested. Computed as (Net Income/Shareholder's Equity) x 100.

Higher profitability ratios are often more favourable as it indicates the company is more efficient at converting its operations into profits.
These ratios should be compared with competitors or industry standards to get a thorough understanding of business’s performance.
Significant changes in the ratios over time could signify changes in the firm’s operations, strategy or competitive environment.

Profitability ratios strictly deal with the earnings of a company, so they may not accurately reflect cash flows, which are also vital in assessing a company’s financial health.
These ratios can greatly vary from one industry to another. So a straightforward comparison among businesses might not be suitable unless they are in the same industry.
They are calculated using accounting data and hence, are prone to manipulation or alteration due to change in accounting policies.

These ratios are particularly important to investors and creditors, as they provide insights into the financial health of the company and its capability to provide returns.
Profitability ratios could be used with other financial analysis tools for a comprehensive understanding of a company’s financial condition.
Most importantly, they provide the basis for growth and survival because earnings are the primary source of cash flows and operational improvement.