Profitability Meaning Formula How To Calculate

Profitability Meaning

The higher the ratio, the better it is because the company performs well.These ratios are often used to compare the performance of companies against each other.Business owners and investment analystsInvestment AnalystsAn investment analyst is an individual or firm that excels in the financial and investment research and have a keen knowledge of financial instruments and models. Such financial professionals include portfolio managers, investment advisors, brokerage firms, mutual fund companies, investment banks, etc.read more use profitability to determine whether it’s wise to invest or not, considering its current and future growth.

How to Analyze Profitability?

Let us take an example of profitability.

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Sales = $50,000Purchase = $30,000Direct CostsDirect CostsDirect cost refers to the cost of operating core business activity—production costs, raw material cost, and wages paid to factory staff. Such costs can be determined by identifying the expenditure on cost objects.read more = $500Rent = $1,000Salary = $3,000General Expenses = $1,500Depreciation = $500Interest Paid = $200Taxes @ 30% = $3,990

Profit = $ (50,000-30,000-500-1,000-3,000-1,500-500-200-3,990)

Profit = $9,310

Let us calculate the most commonly used ratios to calculate profitability.

#1 – Gross Profit Margin

Gross profit marginGross Profit MarginGross Profit Margin is the ratio that calculates the profitability of the company after deducting the direct cost of goods sold from the revenue and is expressed as a percentage of sales. It doesn’t include any other expenses into account except the cost of goods sold.read more is a ratio of gross profit to sales, which means the entity can recover its cost of production from the revenue it is earning. Therefore, the higher the percentage, the better it is.

As per the above example,

Calculation of gross profit will be: –

Gross Profit = Sales – Purchase – Direct Cost

Gross Profit = $(50,000-30,000-500)

Gross Profit = $19,500

Calculation of gross profit margin will be: –

Gross Profit Margin = Gross Profit / Sales

Gross Profit Margin = 19,500/50,000

Gross Profit Margin = 39%

#2 – Net Profit Margin

Net profit marginNet Profit MarginNet profit margin is the percentage of net income a company derives from its net sales. It indicates the organization’s overall profitability after incurring its interest and tax expenses.read more is a ratio of net profit to sales. Net profit is the profit earned after reducing operational costs, depreciation, and dividend from gross profit. A higher ratio/margin means the company is making well enough to cover all its costs and payout to its shareholders or reinvest its profit for growth.

Profitability = $9,310 / 50,000

Profitability = 18.62%.

As calculated above, the net profit margin is 18.62%.

#3 – Operation Profit Margin

Operating profit marginOperating Profit MarginOperating Profit Margin is the profitability ratio which is used to determine the percentage of the profit which the company generates from its operations before deducting the taxes and the interest and is calculated by dividing the operating profit of the company by its net sales.read more is a percentage of earnings to sales before interest expense and income taxes. A higher margin means companies are well equipped to pay for their fixed and operational costs. It also indicates efficient management and their ability to survive in economic downtime compared to their competitors.

Calculation of operating profit will be: –

Operating Profit = Sales – Expenses excluding Interest and Taxes

Operating Profit = $(50,000-30,000-500-1,000-3,000-1,500-500)

Operating Profit = $13,500.

Calculation of operating profit margin will be: –

Operating Profit Margin = Operating Profit / Sales

Operating Profit Margin = 13,500/50,000

Operating Profit Margin =27%.

#4 – EBITDA

Its earnings before interest, tax, depreciation, and amortization. EBITDAEBITDAEBITDA refers to earnings of the business before deducting interest expense, tax expense, depreciation and amortization expenses, and is used to see the actual business earnings and performance-based only from the core operations of the business, as well as to compare the business’s performance with that of its competitors.read more is commonly used to compare a company’s performance with others and is widely used in valuation and project financing.

Calculation of EBITDA will be:-

EBITDA = Sales – Expenses (Excluding Interest, Tax, Depreciation, and Amortization)

EBITDA = $(50,000-30,000-500-1,000-3,000-1,500)

EBITDA = $14,000

Advantages

Some of the advantages are as follows: –

Profitability helps us determine the pricing of our products and services. In many cases, if any revision is required. Pricing is very important for any business, as it leads to increases in net revenueNet RevenueNet revenue refers to a company’s sales realization acquired after deducting all the directly related selling expenses such as discount, return and other such costs from the gross sales revenue it generated.read more. Still, it also has to be at a comparable level with competitors. Therefore, it helps in pricing strategy.Higher profitability is directly related to higher sales. The various ratios and metrics used help compare past data and analyze if the company can survive in a downtime.It helps us in analyzing the return on investment from a business. That means how effectively the company issues its resources to generate value and profit. In addition, it lets us know if the resources are properly deployed and if they can sustain in the future.

Disadvantages

Some of the disadvantages are as follows: –

It does not accurately predict company performance in the future as companies often window dress their accounting statements.Cannot compare a company’s performance across different industries. For example, the analysis of comparing pharmaceuticals with the FMCGFMCGFast-moving consumer goods (FMCG) are non-durable consumer goods that sell like hotcakes as they usually come with a low price and high usability. Their examples include toothpaste, ready-to-make food, soap, cookie, notebook, chocolate, etc.read more industry would not be accurate.

Profitability ratios are key indicators to analyze the performance and liquidity of the company and are derived using income statements. It is also used to determine the strengths and weaknesses and how companies achieve profit from their operations. Analysts use ratios to decide whether or not it is a good proposal for investment purposes. Banking institutions often use such ratios to determine the creditworthinessCreditworthinessCreditworthiness is a measure of judging the loan repayment history of borrowers to ascertain their worth as a debtor who should be extended a future credit or not. For instance, a defaulter’s creditworthiness is not very promising, so the lenders may avoid such a debtor out of the fear of losing their money. Creditworthiness applies to people, sovereign states, securities, and other entities whereby the creditors will analyze your creditworthiness before getting a new loan.read more of a company and sanction loans based on such ratios. Among other ratios, profitability ratios are of utmost importance as all businesses ultimately focus on earning profit and creating value for their stakeholders.