What are Profitability Ratios?

List of Profitability Ratios Formulas

There are different types of profitability ratios that companies use to track their operating performance. However, in this article, we will discuss those based on margin. Three major ratios in this list are 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, 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, and EBITDA marginEBITDA MarginEBITDA Margin is an operating profitability ratio that helps all stakeholders of the company get a clear picture of the company’s operating profitability and cash flow position. It is calculated by dividing the company’s earnings before interest, taxes, depreciation, and amortization (EBITDA) by its net revenue. EBITDA Margin = EBITDA / Net Salesread more, which will cover here.

#1 – Gross Profit Margin Ratio

The gross profit is calculated by deducting all the direct expenses called cost of goods soldCalled Cost Of Goods SoldThe Cost of Goods Sold (COGS) is the cumulative total of direct costs incurred for the goods or services sold, including direct expenses like raw material, direct labour cost and other direct costs. However, it excludes all the indirect expenses incurred by the company. read more from the sales revenue. The cost of goods sold primarily includes raw materials and the labor expense incurred for production. Finally, the gross profit margin is calculated by dividing the gross profit by the sales revenue and expressed in percentages.

Below is the formula to calculate this profitability ratio:-

Gross Profit Margin = (Revenue – Cost of Goods Sold) / Revenue*100%

#2 – Net Profit Margin Ratio

The net profit, called Profit After Tax (PATPATProfit After Tax is the revenue left after deducting the business expenses and tax liabilities. This profit is reflected in the Profit & Loss statement of the business.read more), is calculated by deducting all the direct and indirect expenses from the sales revenue. Then the net profit margin is calculated by dividing the net profit by the sales revenue and is expressed in percentages.

Net Profit Margin = PAT / Revenue * 100%

#3 – EBITDA Margin Ratio

The EBITDA is calculated by adding interest expense, taxes, depreciation, and amortization expense to net profit or profit after tax. Then, the EBITDA margin is calculated by dividing the EBITDA by the sales revenue and is expressed in percentages.

Explanation of the Profitability Ratios Analysis

#1 – How to Calculate Gross Profit Margin?

One can calculate the formula for gross profit margin by using the following steps: –

  • Step #1: Firstly, the sales revenueSales RevenueSales revenue refers to the income generated by any business entity by selling its goods or providing its services during the normal course of its operations. It is reported annually, quarterly or monthly as the case may be in the business entity’s income statement/profit & loss account.read more is taken from the profit and loss account.Step #2: Then, the cost of goods sold is calculated, which is the summation of raw material consumed, labor expense, and other similar direct expenseDirect ExpenseDirect 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 attributable to the product’s manufacturing. All the information is easily available from the profit and loss account.Cost of Goods Sold = Raw Material Cost + Labor Expense + Other Direct ExpensesStep #3:  The gross profit is calculated by deducting the cost of goods sold from the sales revenue.Step #4: Finally, the gross profit margin is calculated by dividing the gross profit by the sales revenue and multiplying by 100%.Gross Profit Margin = (Revenue – Cost of Goods Sold) / Revenue * 100%

#2 – How to Calculate Net Profit Margin?

One can calculate the formula for net profit margin by using the following steps: –

  • Cost of Goods Sold = Raw Material Cost + Labor Expense + Other Direct Expenses

  • Gross Profit Margin = (Revenue – Cost of Goods Sold) / Revenue * 100%

  • Step #1: The sales revenue is calculated as described above.Step #2: The Net Profit After Tax (NPAT) is captured and categorically mentioned as a separate line item in the profit and loss account.Step #3: Finally, the net profit margin is calculated by dividing the Net Profit After Tax (NPAT) by the sales revenue multiplied by 100%.Net Profit Margin = PAT / Revenue * 100%

#3 – How to Calculate EBITDA Margin?

EBITDA margin formulaEBITDA Margin FormulaEBITDA Margin is an operating profitability ratio that helps all stakeholders of the company get a clear picture of the company’s operating profitability and cash flow position. It is calculated by dividing the company’s earnings before interest, taxes, depreciation, and amortization (EBITDA) by its net revenue. EBITDA Margin = EBITDA / Net Salesread more is given below. It can be calculated by using the following steps.

  • Net Profit Margin = PAT / Revenue * 100%

Calculation Examples of Profitability Ratios Analysis

Below we have taken some practical examples to understand this concept.

  • Firstly, the sales revenue is calculated as described above. Interest expense, depreciation, amortization, and paid taxes are taken from the profit and loss account. Then, EBITDA is calculated by adding back interest expense, depreciation amortization expense, and taxes paid to PAT. EBITDA = PAT + Interest + Taxes + Depreciation and Amortization Finally, the EBITDA margin is calculated by dividing the EBITDA by the sales revenue and multiplying by 100%. EBITDA Margin = EBITDA / Revenue * 100%

EBITDA = PAT + Interest + Taxes + Depreciation and Amortization

EBITDA Margin = EBITDA / Revenue * 100%

In the below template is the data for the calculation: –

From the given information,

#1 – Gross profit

= Net sales – Cost of goods sold

So, from the above calculation, gross profit will be: –

#2 – Net profit = $31,000

#3 – EBITDA

= Net profit + Interest expense + Tax + Depreciation expense

So, from the above calculation, EBITDA will be: –

Now, the Profitability ratios,

  • Gross profit margin = Gross profit / Net sales * 100

=53.33%

  • Net Profit Margin = Net profit / Net sales*100%

=20.67%

  • EBITDA Margin = EBITDA / Net sales*100%

=46.67%

Profitability Ratio Analysis in Excel

Now let us take the real-life example of Apple Inc. to illustrate the different profitability ratios in the Excel template below. The table provides detailed calculations using different profitability ratio formulas.

We note the following about the profitability ratios of Apple Inc.: –

  • The net profit margin has increased from 21.19% in 2016 to 22.41% in 2018.On the other hand, the gross profit margin has decreased from 39.08% to 38.34%.Likewise, the EBITDA margin has reduced from 34.01% to 32.77%.

Relevance and Use

  • Profitability ratios are used to assess how a company performs, measured by calculating profitabilityCalculating ProfitabilityProfitability refers to a company’s ability to generate revenue and maximize profit above its expenditure and operational costs. It is measured using specific ratios such as gross profit margin, EBITDA, and net profit margin. It aids investors in analyzing the company’s performance.read more at different levels, i.e., gross profit, profit after tax, and EBITDA.These ratios show the percentage of sales at different levels absorbed by the operating expense. Hence, the lower the operating expense ratioOperating Expense RatioOperating Expense Ratio is the ratio between the cost of operation to the net revenue and is commonly used to evaluate real estate properties. A higher Operating Expense ratio indicates that the company’s operating expenses are higher than its property income, which acts as a deterrent. A lower operating expense ratio implies lower operating costs, which is preferred and investment-friendly.read more, the higher the profitability, indicating better performance.However, there remains a limitation of the profitability ratio as it is useful only when comparing companies in the same industry

Profitability Ratios Formula Video

This article is a guide to the Profitability Ratio. We discuss how to calculate with the help of the profitability ratios formula with examples and a downloadable Excel template, we discuss the formula to calculate profitability ratios (gross margin, net margin, and EBITDA margin). You can learn more about financial analysis from the following articles: –

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