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# Profitability Ratio

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Reviewing, assessing and comparing financial statements is a good way to analyse the financial performance of a business. However, for the analysis to be more valuable, it is useful to calculate and analyse the financial ratios. The most significant financial ratios are those that state the profitability of a business. Let's find out what profitability ratios are exactly.

## Profit ratio: Definition

To understand what profit ratios are, it is crucial to first understand what financial ratios are.

Financial ratios calculate and compare the relationship between two or more elements of financial data sourced from a business's financial statements such as income statements or balance sheets.

Example of a financial ratio:

$\frac{x}{y}×100=?$Although there are numerous financial ratios, the most significant ones are typically those that state the profitability of a business.

Profitability is the ability of a business to generate profits from its operations. It is measured using income and expenses.

Simply put, profitability refers to how a business makes money from what it does. It relates to how a business earns income considering its expenses.

Profit ratios compare a business’s profit to another figure from its financial statements. They typically compare profit to revenue earned.

### Profitability Ratio: Gross profit and net profit

There are two profit figures that can be used to calculate profit ratios: gross profit and net profit.

• Gross profit is the profit made by a business after subtracting all the costs related to manufacturing and selling its products.

If revenue is £100 and costs are £20, then the gross profit will equal £80.

• Net profit is the profit made by a business after all of its expenses have been subtracted from revenues. These expenses include costs related to manufacturing and selling products, interest, taxes, and any other expenses.

If revenue is £100, costs £20, and tax £5, then the net profit will equal £75.

To sum up, gross profit includes costs related to manufacturing and selling products, whereas net profit includes all the expenses.

Gross profit and net profit figures can be found in the income statement.

## Types of profit ratios

There are two financial ratios that help analyse the profitability of a business: gross profit margin and net profit margin.

### Profitability Ratio: Gross profit margin

The gross profit margin shows the amount of money leftover from product sales after subtracting the cost of goods sold (the amount the business spent on manufacturing the product).

The gross profit margin compares a business’s gross profit for a trading period with its revenue for the same year. It is expressed as a percentage. The higher the value, the more gross profit a firm is generating from its sales.

The formula for calculating gross profit margin is the following:

$GPM =\frac{Grossprofit}{Revenue}×100$

If gross profit is £110,000 and revenue is £100,000, then gross profit margin will be 110%.

$GPM=\frac{110,000}{100,000}×100=110%$

However, is 110% a good value for gross profit? It is hard to say by just looking at this one figure. To answer this question, one should compare the value with:

• A business’s target for its gross profit margin

• A business’s gross profit margin from previous years

• The gross profit margin of other similar businesses.

### Profitability Ratio: Net profit margin

The net profit margin shows how much net profit or income is generated as a percentage of revenue.

The net profit margin compares a business’s net profit for a trading period with the revenue for the same year. It is expressed as a percentage. The higher the value, the more net profit a business is generating from its sales.

The formula for calculating net profit margin is the following:

$NPM =\frac{Netprofit}{Revenue}×100$

If net profit is £300,000 and revenue is £330,000, then net profit margin will be 91%.

$NPM=\frac{300,000}{330,000}×100=91%$

It means that £0.91 in each £1 is net profit.

However, is 91% a good value for net profit? As with the gross profit margin, it is hard to say by just looking at this one figure. To answer this question, one should compare the value with:

• A business’s target for its net profit margin

• A business’s net profit margin from previous years

• The net profit margin of other similar businesses.

In general, the net profit margin can be a better indicator of a business's financial performance in terms of profitability. This is because compared to gross profit margin, which includes a business’s costs of sales only, net profit margin includes all costs paid by a business.

## Profit ratios - Key takeaways

• Financial ratios calculate and compare the relationship between two or more elements of financial data sourced from a business's financial statements, such as income statements or balance sheets.
• Profitability is the ability of a business to generate profits from its operations. It is measured using income and expenses.
• Profit ratios compare a business’s profit to another figure from its financial statements. They typically compare profit to revenue earned.
• Gross profit is the profit made by a business after subtracting all the costs related to manufacturing and selling its products.
• Net profit is the profit made by a business after all of its expenses have been subtracted from revenues. These expenses include costs related to manufacturing and selling products, interest, taxes, and any other expenses.
• There are two financial ratios that help analyse the profitability of a business: gross profit margin and net profit margin.
• The gross profit margin shows the amount of money left over from product sales after subtracting the cost of goods sold.
• The net profit margin shows how much net profit or income is generated as a percentage of revenue.

## Profitability Ratio

Profit ratios compare a business’s profit to another figure from its financial statements. They typically compare profit to revenue earned.

To state the profitability of a business. Profitability is the ability of a business to generate profits from its operations. It is measured with income and expenses. Simply put, profitability refers to how a business makes money from what it does.

Profit ratios can be calculated by comparing a business’s profit to revenue earned.

Gross profit margin and net profit margin.

## Final Profitability Ratio Quiz

Question

Define financial ratios.

Financial ratios calculate and compare the relationship between two or more elements of financial data sourced from a business's financial statements, such as income statements or balance sheets.

Show question

Question

What is profitability?

Profitability is the ability of a business to generate profits from its operations. It is measured using income and expenses.

Show question

Question

What are the profit ratios?

Profit ratios compare a business’s profit to another figure from its financial statements. They typically compare profit to revenue earned.

Show question

Question

What is the gross profit?

Gross profit is the profit made by a business after subtracting all the costs related to manufacturing and selling its products.

Show question

Question

What is the net profit?

Net profit is the profit made by a business after all of its expenses have been subtracted from revenues. These expenses include costs related to manufacturing and selling products, interest, taxes, and any other expenses.

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Question

What is the difference between gross profit and net profit?

Gross profit includes costs related to manufacturing and selling products whereas net profit includes all the expenses.

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Question

What are the two financial ratios that help to analyse the profitability of a business?

There are two financial ratios that help analyse to the profitability of a business: gross profit margin and net profit margin.

Show question

Question

Where do we find gross profit and net profit figures?

Income statement

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Question

What is the gross profit margin?

The gross profit margin shows the amount of money left over from product sales after subtracting the cost of goods sold.

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Question

What is the net profit margin?

The net profit margin shows how much net profit or income is generated as a percentage of revenue.

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Question

How does one assess whether a figure is a good value for gross or net profit margin?

To answer this question, one should compare the value with:

• A business’s target for its gross or net profit margin
• A business’s gross or net profit margin from previous years
• The gross or net profit margin of other similar businesses

Show question

Question

Why can the net profit margin be a better indicator of a business's financial performance in terms of profitability than gross profit margin?

Compared to gross profit margin, which includes a business’s costs of sales only, net profit margin includes all costs paid by a business.

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Question

Which statement is true?

The higher the values of profit ratios, the more gross or net profit a business generates from its sales.

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Question

___  is the ability of a business to generate profits from its operations. It is measured using income and expenses.

Profitability

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Question

___ is the profit made by a business after subtracting all the costs related to manufacturing and selling its products.

Gross profit

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Question

___ is the profit made by a business after all of its expenses have been subtracted from revenues. These expenses include costs related to manufacturing and selling products, interest, taxes, and any other expenses.

Net profit

Show question

Question

If revenue is £100, costs £20, and tax £5, then the net profit will equal...

£75.

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Question

If revenue is £100, costs £20, and tax £5, then the net profit will equal

£80.

Show question

Question

The ___ shows the amount of money leftover from product sales after subtracting the cost of goods sold (the amount the business spent on manufacturing the product).

gross profit margin

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Question

If net profit is £300,000 and revenue is £330,000, then net profit margin will be...

91%.

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Question

If gross profit is £110,000 and revenue is £100,000, then gross profit margin will be...

110%.

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Question

The ___ the value of gross profit margin, the more gross profit a firm is generating from its sales.

higher

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Question

The higher the value of NPM, the more ___ a business is generating from its sales.

net profit

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Question

Gross profit and net profit figures can be found in the...

income statement.

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Question

GPM of company A was 120% in 2019 and 130% in 2020. Which year was better for the company?

2020

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Question

NPM of company B was 80% in 2019 and 75% in 2020. Which year was better for the company?

2019

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