Introduction to Profitability Ratios

The ultimate aim of all business is to generate profit. That is what the investors invest for, management plans for and employees execute for.

Profitability Needs Context

Two companies may be generating the exact same amount of rupee profits, however that does not mean that they are equally profitable. This is because profit is an output measure. And jumping to a conclusion only by looking at the output and not the input that was used to generate the output would not be very prudent!

The profit numbers are therefore seen in relation to various measures of inputs like capital, equity, assets etc. Each of these measures tell a separate story about how the company is performing specific to the input. Analysts often use these numbers together, connect the dots and find out the true picture of the company’s profitability.

Different User Groups Have Different Needs

Shareholders want the business to generate as much profit as possible. Debt holders on the other hand are content with enough money to ensure that they get paid. Banks want to know whether the company has been making efficient use of fixed assets before granting a loan to buy another one. Thus different user groups have different needs. Hence there is a need for a wide variety of profitability ratios that serves them.

Drivers of Profitability

A careful analysis of the profitability ratios also unearths the drivers of profitability. Analysts can look at the financial ratios of an extended period of time and use correlation analysis to unearth the same. The ability to express the company’s business as an accurate input output model is vital for analysts. This is because they can then guess the input, obtain the output and value the firm based on this information.

Common drivers of profitability include economies of scale, economies of scope, mechanization, automation, investment in brand value etc.

Cycles and Trends

Industries have their specific business cycles. These business cycles have similar duration and the highs and lows that the business will experience can also be gauged fairly accurately. Profitability ratios help in doing the same.

Analysts use ratios from past several years and then conduct a trend analysis to find out the patterns hidden in the data. This helps them find out how the sales are expected to move in the next quarter.

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