Profit Ratio
A profit ratio is a measure of a company’s profitability, expressed as a percentage of the company’s revenues. This means it shows how much of the company’s revenues are turned into profits. It’s also often referred to as a profit margin.
There are several types of profit ratios:
- Gross Profit Ratio: Also known as the gross profit margin, this ratio shows the proportion of money left over from revenues after accounting for the cost of goods sold (COGS). It’s calculated as follows:
Gross Profit Ratio = (Gross Profit / Revenue) x 100 - Operating Profit Ratio: Also known as the operating profit margin, this ratio indicates the proportion of revenue left after all operating costs, like wages, rent, and utilities, but before interest and taxes. It’s calculated as follows:
Operating Profit Ratio = (Operating Profit / Revenue) x 100 - Net Profit Ratio: Also known as the net profit margin, this ratio indicates the percentage of revenue left after all expenses, including taxes, interest, and non-operating expenses. It’s the most precise measure of a company’s profitability. The formula is:
Net Profit Ratio = (Net Profit / Revenue) x 100
These ratios help analysts, investors, and managers assess a company’s profitability and compare it with other businesses in the same industry. The higher these ratios are, the more profitable the company is considered. However, what constitutes a “good” profit ratio can vary significantly from one industry to another.
Example of a Profit Ratio
let’s consider a fictitious company, “Comfy Couch Inc.”, that manufactures and sells furniture. Below are some numbers from its income statement for the past fiscal year:
- Revenue (Sales): $1,000,000
- Cost of Goods Sold (COGS): $600,000
- Operating Expenses (like wages, rent, etc.): $200,000
- Interest Expenses: $50,000
- Taxes: $50,000
Let’s calculate the three types of profit ratios for this company:
- Gross Profit Ratio:
First, calculate the Gross Profit:
Gross Profit = Revenue – COGS = $1,000,000 – $600,000 = $400,000
Then, calculate the Gross Profit Ratio:
Gross Profit Ratio = (Gross Profit / Revenue) x 100 = ($400,000 / $1,000,000) x 100 = 40%
- Operating Profit Ratio:
First, calculate the Operating Profit:
Operating Profit = Gross Profit – Operating Expenses = $400,000 – $200,000 = $200,000
Then, calculate the Operating Profit Ratio:
Operating Profit Ratio = (Operating Profit / Revenue) x 100 = ($200,000 / $1,000,000) x 100 = 20%
- Net Profit Ratio:
First, calculate the Net Profit:
Net Profit = Operating Profit – Interest – Taxes = $200,000 – $50,000 – $50,000 = $100,000
Then, calculate the Net Profit Ratio:
Net Profit Ratio = (Net Profit / Revenue) x 100 = ($100,000 / $1,000,000) x 100 = 10%
In this example, for every dollar Comfy Couch Inc. makes in sales, it has a gross profit of 40 cents, an operating profit of 20 cents, and a net profit of 10 cents. These profit ratios provide insights into the company’s profitability at different stages of its operations.
