– Profitability compares the business revenue against all economic costs and evaluates how productivity a business is utilizing its resources, both capital and human.

– Profitability measures the extent to which a farm business generates a profit from the use of land, labor, management, and capital.

– Profitability ratios (also referred to as profit margin ratios) compare components of income with sales.

– They give us an idea of what makes up a company’s income and are usually expressed as a portion of each dollar of sales.

Numerically,

I) Gross Profit = Net sales − cost of goods sold

ii) Net sales = gross sales − returns − discounts

iii) Operating profit = Gross profit − selling and administrative expenses

[Administrative expenses are salaries, payroll tax, benefits, rent, utilities, office supplies, insurance, depreciation, etc. Operating profit includes all expenses except income tax]

iv) Net Profit = Operating Profit (plus any other income) − Additional Expenses − Tax

[Net profit is what is known as ‘the bottom line]

The following are major ratios for  Profitability ratios

a) Gross Profit Margin Ratio:

– Gross profit is what is left after the costs of goods sold have been subtracted from net sales.

– It is the price of the goods, including inventory or raw materials and labor used in production, but it does not include selling or administrative expenses.

– The ratio of gross profit as a percentage of sales is an important indicator of your company’s financial health.

– Without an adequate gross margin, a company will be unable to pay its operating and other expenses and build for the future.

Mathematically,

Gross Profit Margin ratio = (Gross profit/sales)x 100.

b) Operating Profit Margin:

– The operating profit margin is the ratio of operating profit (also known as EBIT 2 , operating income, income before interest and taxes) to sales.

– The operating profit margin is an indicator of your company’s earning power from its current operations.

– In general, the operating profit margin is an indicator of management skill and operating efficiency.

– It measures the company’s ability to turn sales into pre-tax profits.

Numerically,

Operating Profit Margin = (Operating profit/sales) x 100

c) Net Profit Margin Ratio:

– The net profit margin is the ratio of net income (also known as net profit) to sales, and indicates how much of each rupee of sales is left over after all expenses.

Mathematically,

Net Profit Margin ratio = (Net profit/sales) x 100.