Profitability Ratios: What Is It and How Can It Help Your Business?
One of the most important financial metrics that your company should be tracking is your profitability ratio. If you haven’t been doing that, this is as good a time as any to start.
If you don’t know what the profitability ratio is, then you’re in the right place. We’ll outline everything you need to know about profitability ratios in this article to help you gain a better image of how your company is doing.
What Are Profitability Ratios?
Profitability ratios are defined as financial metrics and key performance indicator (KPI) that is used to measure the company’s financial performance. It tells how efficient the business is in coming up with a profit relative to its expenses, sales, assets, equity, and other variables. It also tells how the company’s funds are utilized.
In general, profitability ratios provides company owners, shareholders, and accountants an insight into the following factors:
- How much the company has to pay for immediate debts;
- How your company’s valuation ratios (company share earnings) are;
- Your company’s ability to pay for long-term debts and;
- How efficient your company is in utilizing its financial resources.
It’s one of the key metrics that accountants use in determining how well the company is performing during that particular period or a quarter of the year.
What is the Importance of Profitability Ratios?
When running a business, one of the things that you should be concerned about is how your business is performing compared to the previous month, quarter, or year. Profitability ratios allow you to do just that. It also gives you an insight into how your company is doing compared to the others in the industry.
By calculating and assessing your profitability ratios, a business can tell whether their efforts are leading to a better bottom line or not.
Types of Profitability Ratios
To make an accurate analysis of your company’s profitability ratios, you have to understand the different types of ratios there is and how to calculate each one of them. The types of profitability ratios include earnings per share (EPS), return on equity (ROE), and
dividend per share. Here’s how each one of the ratios works:
1. Earnings Per Share (EPS)
This ratio tells the company’s managers how much of the company’s income is available for payment for each shareholder or the company’s holders of the common stock. If the ratio shows a positive trend, then the company is said to be efficient in managing its earnings or buying back its stocks.
Below is the formula for a company’s earnings per share (EPS) ratio:
Earnings per share (EPS) = net profit/total # of outstanding shares
2. Return on Equity (ROE)
The company’s return on equity (ROE) shows how well the company is doing when it comes to utilizing the shareholders’ investments in generating profits. Since it’s based on the shareholder’s share, this ratio shows how much the shareholders get in return for their investment in your company. The higher the ratio, the better the company is in utilizing the shareholders’ shares.
Here’s how you can calculate your company’s ROE:
ROE = Profit after Tax/Net Worth
Where, net worth translates to equity share capital, and reserve and surplus
3. Dividend Per Share
The company’s dividend of share determines the amount of dividend in the company that is available for its shareholders. A high dividend per share means the company has more surplus cash stored.
To compute a company’s dividend per share, use this formula:
Dividend per Share = Amount distributed to shareholders/Number of outstanding shares
5 Ways to Improve Your Company’s Profitability Ratios
If your company’s profitability ratios are declining or it’s not doing as well as the previous quarter, there are some things that you can do to improve your company’s performance. Here are five tips you can follow to improve your company’s bottom line:
1. Remove Products That Are Not Generating Profits
Since you’re focusing on generating income in your company, cutting unprofitable products in your line-up will save you a lot of money. Instead, focus on the products that are generating the highest sales and income for your business.
2. Cut Back on Inventory
One of the biggest expenses in your business will go to your inventory. If you notice some slow-moving products, consider reducing the volume of that specific goods. The lesser cash is tied up on your inventory, the better your company’s cash flow and profitability ratios will be.
3. Raise Your Prices
Increasing your products’ prices is also an effective way of boosting your profitability ratios. However, be sure to test it out first to assess whether the change will appeal to your audience.
4. Cut Back on Your Business Costs
Overhead and operating expenses can take up much of your company’s profits. Even if your company incurs a lot of sales every month, if your bills and other costs are high, it will eat up all your profits leaving you with little to go on. With that, it’s important to consider cutting back on costs. You can do this in a lot of ways. This include:
- Renegotiating prices with your vendors
- Refinancing loans to pay lesser interests
- Renting out your extra office space
5. Get More Clients
In reality, it’s much cheaper to market your business to your current customers than to attract new ones. However, if you plan your strategies carefully, attracting new customers to your company may lead to a significant increase in your sales. What makes this better is that if you’ve recently made changes to your product prices, it’s much easier to have your new clients pay the increased prices.
Conclusion: Profitability Ratios
Tracking your financial ratios are one of the most important things you should do as a business owner. Profitability ratios help business owners know in what area in their business they’re losing more money and which areas are managed efficiently. This helps the owners and shareholders identify the places where they should focus more. From there, they can create plans and strategies that will help them address the issues and eventually increase their company’s bottom line.
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