Profitability Ratios

This ratio is calculated to analyze the ability of the business to generate profit. The profitability ratio is useful in understanding the financial statement of the organization. In most of the cases the ratio having a higher value indicates that the company is performing well. In some of the cases the company performance is compared with the previous year performance. It is important that the person who is calculating these ratios must have some basic knowledge of accounting. There is nearly 200 profitability ratios.

Some of the ratios that comes under the category of profitability ration are,

• Return on asset
• Return on sales
• Profit margin ratio
• Gross profit margin
• Operating profit margin
• Cash flow margin
• Earning per share etc.

It should be noted that profitability ratio must be calculated with proper care. Even small things like selection of quarters for various ratio calculations must be made with utmost care, because in some case if selection of quarters is wrong then that might result in weird results which got no connection with the actual performance.

Profitability ratios are usually used to compare the past performance of an organization with the present. It is also used to compare the performance of one company with another. These ratios are widely used by the managers to find out the performance of the company. It is not easier to find out the actual performance of the company from the financial statement and hence managers use these ratios to clearly understand the position.

The key advantage in using profitability ratios in financial decisions are,

• Quick understanding of the financial statement and the performance of the company is possible, which helps in quick decision making.
• The above condition enables the lender, owner, manager to work in a proper direction and hence achieve a higher growth and higher profit.
• The future financial decision can be made based on these calculations.

The profitability ratios too has some constraints they are

• They vary along with variation in accounting method.
• They are valid only along with financial statement, but when used alone they have no values.