Know the Definition, Types, and How to Calculate the Profitability Ratio
In carrying out business activities, business actors certainly need to know the definition, type, and method of calculating the profitability ratio. This is useful to help them manage company finances properly.
Definition of the Profitability Ratio
Profitability ratio is a ratio used to assess a company's ability to generate profits and seek profit from its business activities. This ratio also provides a measure of the level of management effectiveness of a company.
This is indicated by the profit generated from sales and investment income. The use of this ratio also shows the efficiency of the company.
This ratio illustrates the company's ability to generate profits through all its capabilities and resources, namely sales activities, use of assets, and use of capital.
From an investor's perspective, the company's profit growth is an important indicator to assess the company's prospects in the future. It is important to pay attention to the extent to which the investment that investors will make in a company is able to provide returns in accordance with the level expected by investors.
Function and Purpose of Using the Profitability Ratio
For business actors, the profitability ratio aims to measure the level of management effectiveness in carrying out company operations. The measurement of profitability ratios is carried out to monitor and evaluate the level of development of company profits from time to time.
Information related to profitability ratios certainly has a very important function for the business you run. Some of the functions include:
- Knowing the level of the company's ability to generate profits in a certain period.
- Compare and assess the company's profit position from the previous year with the current year.
- Knowing the progress of profit over time.
- Measures how much the amount of net profit generated from the funds invested in total assets and total equity.
- Knowing the level of net profit after tax with own capital.
- Knowing the productivity of all company funds used, both loan capital and own capital.
- Measure the gross profit margin on net sales, measure the operating profit margin on net sales, and measure the net profit margin on net sales.
Types of Profitability Ratios
1. Return on Investment (RoI)
Return on Investment (RoI) is a type of profitability ratio that shows the return on the amount of assets used in the company. RoI is also a measure of management effectiveness in managing its investment.
2. Return on Equity (RoE)
Return on Equity (RoE) can be interpreted as the result of return on equity or profitability of own capital. RoE is a ratio to measure net profit after tax with own capital.
This ratio shows the efficiency of using one's own capital, so that the higher the ratio, the better the efficiency. This means that the position of company owners is getting stronger.
Likewise, when the ratio is low, efficiency is not optimal and the position of the company owner is getting weaker.
Basically, RoE describes the extent to which the company's ability to generate profits that can be obtained by shareholders. RoE can be calculated by dividing net income by the total equity of the company.
3. Return on Assets (RoA)
Return on Assets (RoA) describes the extent to which the company's assets can generate net income. RoA is obtained by dividing profit before interest and taxes by the total assets of the company. However, different literature states that how to calculate RoA which is one type of profitability ratio can be done by dividing net income by total assets.
4. Earnings per Share
The ratio of earnings per share or Earning per Share is a ratio to measure the success of management in achieving benefits for shareholders. A low ratio means that management has not succeeded in satisfying shareholders, on the contrary, with a high ratio, the welfare of shareholders increases or the rate of return is high.
5. Operating Profit Margin
Operating Profit Margin is a ratio used to measure the percentage of operating profit on net sales. The ratio is calculated by dividing operating profit against net sales.
Operating profit is calculated as a result of the deduction between gross profit and operating expenses. Meanwhile, operating expenses consist of selling expenses, general and administrative expenses.
6. Gross Profit Margin
Gross Profit Margin or Gross Profit Margin is a ratio used to measure the percentage of gross profit on net sales. This ratio is calculated by dividing gross profit against net sales.
Gross profit itself is calculated as the result of subtracting net sales from cost of goods sold. Meanwhile, net sales represent sales less returns and selling price adjustments and sales discounts.
7. Net Profit Margin
Net Profit Margin or Net Profit Margin is a ratio used to measure the percentage of net income on net sales. The ratio is calculated by dividing net income against net sales.
Net income is calculated as a result of the deduction between profit before income tax and income tax expense.
Knowing the Company's Performance with the Income Statement
How to Calculate the Profitability Ratio
RoE = Net Income / Total Equity (Own Capital).
In the calculation of RoE, the higher the return on equity, the higher the amount of net profit generated from each rupiah of funds invested in equity.
Conversely, the lower the return on equity means the lower the amount of net income generated from any funds that are embedded in equity.
RoA Calculation Formula:
RoA = Net Income / Total Assets
This means that the higher the return on assets, the higher the amount of net profit generated from each rupiah of funds invested in total assets.
Conversely, the lower the return on assets means the lower the amount of net income generated from each fund invested in total assets.
Operating Profit Margin Calculation Formula:
Operating Profit Margin = Operating Profit / Net Sales.
This means that the higher the operating profit margin, the higher the operating profit generated from net sales. This can be due to high gross profit or low operating expenses.
Conversely, the lower the operating profit margin means the lower the operating profit generated from net sales. This is due to low gross profit or high operating expenses or both.
Gross Profit Margin Calculation Formula:
Gross Profit Margin = Gross Profit / Net Sales
This means that the higher the gross profit margin, the higher the gross profit generated from net sales. These results can be due to high selling prices or low cost of goods sold or both.
Conversely, the lower the gross profit margin, the lower the gross profit generated from net sales. This can be due to a low selling price or a high cost of goods sold or it could be both.
Net Profit Margin Calculation Formula:
Net Profit Margin = Net Profit / Net Sales
This means, the higher the net profit margin, the higher the net profit generated from net sales. This can be due to the high profit before income tax.
Conversely, the lower the net profit margin, the lower the net profit generated from net sales. This could be due to the low profit before income tax.
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