Investing in the share market can prove to be highly beneficial if you make investment decisions based on extensive research. The research generally includes analysing the company and ensuring that its stock will increase in price in the near future. You can analyse a company based on numerous metrics, and one of the most utilised is the profitability ratio.
This blog will help you learn what profitability ratio is and its types.
Read more: What is share market
What is the profitability ratio?
Profitability ratio’s meaning refers to financial metrics used by investors to evaluate a company’s ability to generate income compared to its expenses, operating costs, revenue, assets, equity, and other financial elements.
Importance
Investors use profitability ratios to evaluate a company's financial health and performance. The profitability ratio helps investors gain insights into how effectively a company manages its resources to produce earnings. If profitability ratios are in support of the company’s stock, it is likely to rise in price in the near future.
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Types of profitability ratios
Now that you know about the profitability ratio’s meaning and its importance, let us move on to the types of profitability ratios:
- Return on equity
- Earnings per share
- Dividend per share
- Price-earnings ratio
- Return on capital employed
- Return on assets
- Gross profit
- Net profit
Return on equity
Return on equity measures a company’s ability to earn returns on its equity investments. A higher ROE means that a company can generate cash without relying heavily on debt. The formula for ROE is net income/shareholders equity.
Earnings per share
Earnings per share measures the profits earned by each common stock from a shareholder's point of view. It indicates a company’s profitability on a per-share basis. The formula for EPS is (net income - dividends on preferred stock)/weighted average of outstanding shares.
Dividend per share
Dividend per share measures the amount of dividends paid by a company to each of its outstanding shares of common stock. It helps investors to analyse a company’s stock based on its potential to provide returns as dividends. The formula for dividend per share is total dividends paid annually/total number of outstanding shares.
Price-earnings ratio
The price-earnings ratio allows investors to analyse a company stock based on its valuation. It measures the current share price relative to the company's earnings per share (EPS). Investors use the price-earnings ratio to understand whether the stock is undervalued or overvalued. The formula for the P/E ratio is market price per share/earnings per share.
Return on capital employed
Return on capital employed analyses the returns that funds invested by the owners have generated for the business. A higher ROCE indicates that the company has used the funds invested by the owners more efficiently, which may lead to a higher stock price. The formula for ROCE is earnings before interest and tax (EBIT)/capital employed. Here, capital employed is the difference between total assets and current liabilities or equity plus non-current liabilities.
Return on assets
Return on asset measures the amount of earnings made through the assets invested in the company. It helps investors understand how effectively the company is utilising its assets to generate income. If ROA is higher, it means that a company with a higher pool of assets has the potential to generate higher revenues. The formula for ROA is net income/total assets.
Gross profit ratio
The gross profit ratio, also known as gross profit margin, shows the revenue percentage generated by a company relative to its cost of goods sold. It measures a company's efficiency in producing and selling its products and earning higher revenue. A high gross profit ratio or margin implies that the company has the potential to manage production costs and earn better revenue. The formula for gross profit margin is (gross profit/sales) x 100. Here, gross profit is the difference between revenue and the cost of goods sold.
Net profit ratio
Net profit ratio, also known as net profit margin, measures the percentage of the amount that remains as net profit after all direct and indirect expenses. These expenses may include operating expenses, interest, taxes, and preferred stock dividends. Net profit margin allows investors to gauge the overall profitability and efficiency of a company in managing its total expenses relative to its revenue. The formula for net profit margin is (net profit/net sales) x 100. Here, net profit is operating profit - (direct cost plus indirect expenses), while net sales is sales minus returns.
Read more: Share market basics
Conclusion
Profitability ratios are financial metrics that are tremendously useful for investors to analyse a company based on its potential to utilise its resources and make profits. If profitability ratios are positive for a company, the stock has a better chance to provide good returns through dividends and capital appreciation.
However, it is important that you analyse a company and its stock based on other technical and fundamental factors along with profitability ratios. Now that you know the profitability ratio’s meaning, you are better equipped to make informed investment decisions.
