Profit ratio | Profit margin ratio
/What is the Profit Ratio?
The profit ratio compares the earnings reported by a business to its sales. It is a key indicator of the financial health of an organization, and is closely followed by investors. The profit margin ratio is customarily used in each month of a month-to-month comparison, as well as for annual and year-to-date income statement results. A decline in the profit ratio may trigger a decline in a firm’s stock price, since investors will assume that its longer-term prospects have now declined.
How to Calculate the Profit Ratio
The profit ratio formula is to divide the net profits for a reporting period by the net sales for the same period. The calculation is:
Net profit ÷ Net sales = Profit ratio
For example, ABC International has net after-tax profits of $50,000 on net sales of $1,000,000, which is a profit ratio of:
$50,000 Profit ÷ $1,000,000 Sales = 5% Profit ratio
If a firm’s profits bounce around from period to period, it can make sense to only run this calculation for longer periods of time, such as quarterly or annually, in order to obtain a more consistent view of its profitability performance.
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Problems with the Profit Ratio
The profit ratio suffers from several flaws. First, it includes items that do not relate to the core operations of the business, such as interest income and interest expense. For example, a financing gain could mask an operating loss. Second, it does not necessarily match cash flows, since a variety of accruals required under accrual accounting can cause major divergences between profit or loss figures and cash flows. And third, it is easily adjusted with accounting chicanery, such as using aggressive accruals or altering accounting policies. For these reasons, it is best to use the profit ratio in conjunction with a variety of other metrics to ascertain the true financial health of a business.
Profit Ratio vs. Gross Profit Ratio
The profit ratio is sometimes confused with the gross profit ratio, which is the gross profit divided by sales. It yields a much higher margin percentage than the profit ratio, since the gross profit margin ratio does not include the negative effects of selling, administrative, and other non-operating expenses.
Terms Similar to Profit Ratio
The profit ratio is also known as the net profit margin ratio.