Profitability ratios are the financial ratios which talk about the profitability of a business with respect to its

sales or investments. Since the

ratios measure the efficiency of operations of a business with the help of profits, they are called profitability ratios. They are quite useful tools
to understand the efficiencies/inefficiencies of a business and thereby assist management and owners to take corrective actions.

PURPOSE AND IMPORTANCE

A business starts with a motto of making a profit and thus one of the most commonly used financial ratios is the profitability ratios. Since every
business wants to generate profit and the investors also want returns on their investments, it is mandatory to showcase how the company is
working and generating profit. Thus, profitability ratios analysis is an important evaluation criterion for companies.

Profitability ratios are the tools for financial analysis which communicate about the final goal of a business. For all the profit-oriented
businesses, the final goal is none other than the profits. Profits are the lifeblood of any business without which a business cannot remain a
going concern. Since the profitability ratios deal with the profits, they are as important as the profits.
The purpose of calculating the profitability ratios is to measure the operating efficiency of a business and returns which the business
generates. The different stakeholders of a business are interested in the profitability ratios for different purposes. The stakeholders of a
business include owners, management, creditors, lenders etc.

There are various profitability ratios which are used by companies to provide useful insights into the financial well-being and performance of
the business.

All of these ratios can be generalized into two categories, as follows:

Ultimately, these ratios are nothing but a simple comparison of various levels of profits with either SALES or INVESTMENT. So, these ratios can
be further classified as Margin Ratios (Sales based Ratios) and Return Ratios (Investment based Ratios).

BREAK EVEN POINT

In simple words, the break-even point can be defined as a point where total costs (expenses) and total sales (revenue) are equal. Break-even
point can be described as a point where there is no net profit or loss. The firm just “breaks even.” Graphically, it is the point where the total
cost and the total revenue curves meet.

MARGIN OF SAFETY

The concept is useful  when a significant proportion of sales are at risk of decline or elimination, as may be the case when a sales
contract is coming to an end.  A minimal margin of safety might trigger action to reduce expenses. The opposite situation may also
arise, where the margin of safety is so large that a business is well-protected from sales variations. The margin of safety concept is
also applied to investing.

CONTRIBUTION MARGIN RATIO

The contribution margin should be relatively high, since it must be suffi cient to also cover fixed costs and  administrative overhead .
Also, the measure is useful for determining whether to allow a lower price in special pricing situations. If the contribution margin
ratio is excessively low or negative, it would be unwise to continue selling a product at that price point, since the company would
have considerable diffi culty earning a profit over the long term. However, there are cases where it may be acceptable to sell a
package of goods and/or services where individual items within the package have a negative contribution margin, as long as the
contribution margin for the entire package is positive. 

MARGIN RATIO – GROSS PROFIT MARGIN

This is the ratio which is used to understand how much cost incurred to manufacture a product. It also helps in understanding the efficiency of
the company and how is it using its resources to produce the product and then make a profit by passing the cost incurred to the consumers of
the product.

MARGIN RATIO – NET PROFIT MARGIN

Net profit margin shows the margin left for the equity and preference shareholders i.e. the owners. Unlike the gross profit which measures the
operating efficiency of the business, it measures the overall efficiency of the business. An adequate margin of net profits will be generated
only when most of all the activities are being done efficiently. The activities may be production, administration, selling, financing, pricing, tax
management or inventory management. Even if any of these perform badly, the effect on net profits and their margins can be seen.
RETURN RATIO - RETURN ON ASSETS

It is the profitability ratio which is used to evaluate the company’s level of efficiency in employing its assets to generate profit. The assets of
the company if not used optimally will not be able to make the desired amount of profit and the return will also be lower.

RETURN RATIO – RETURN ON EQUITY

Every equity investor looks for this ratio before investing in any company as it gives the insight into the company’s profit-generating ability to
the investors. The potential, as well as existing investors, keep a check on this ratio as it measures the return on the investment made in shares
of the company. In general, the higher the ratio, more favorable it is for the investors to invest in the company.

RETURN RATIO – RETURN ON OPERATING ASSETS

Return on assets used in operations measures the ability of a company’s general business operations to produce revenue by comparing the
net income produced with the current value of assets employed in operations. In other words, it shows profitability from day-to-day
production resources. Some examples of operating assets include cash, accounts receivable, inventory and the fixed assets that contribute to
everyday operations.
The revenue producing assets are required to carry out business functions, but the return on these assets can let company management know
how much value these necessary assets add. After all, if a particular piece of expensive equipment makes little or no marginal increase in
revenue, it would be wise to find a less expensive piece of equipment that can do the same job.

Comparing the return on operating assets to the return on total assets can also provide some insight on which assets are truly beneficial to
own. Total assets would include long-term assets and investments outside general revenue production that may not be as liquid. By focusing
solely on the operating assets, where a company has more control over costs, income can be boosted by process improvements.