Profitability ratio indicates whether the business is making a profit: this metric can seem complex.
It is important since the financial health of the company is what guarantees its permanence in the market, being an indispensable factor for SMEs.
When a considerably “expensive” project appears, and you don’t know if it’s really worth taking it forward.
This index can be a first step in designing plans and goals, and from there monitoring the results achieved with the investment .
And, to help you, we’ve prepared below a step-by-step guide on how to check your company’s index. See below!
What is a profitability index?
Organizations should not go ahead with the idea of conducting their business without very well-developed technical knowledge, especially with regard to their financial management.
Bearing this in mind, the profitability index is the metric that indicates whether the work being done generates a good financial return and the company is able to pay for itself.
It is also possible to evaluate a certain area of the business separately with this indicator.
In simpler lines, let’s highlight at which key points the index is important:
- Provides an expanded view of all departments of the company;
- Assists in decision making;
- It can direct the behavior of investors;
- Demonstrates whether current practices are being effective or not;
- Reveals the profit margin of the business.
Given the benefits mentioned above, it becomes more evident why the implementation of this tool is essential.
Through this tool, it is also possible for companies to clearly know if there is a need to correct the strategy to reverse declines in profitability.
In addition, a good profitability index is a credibility parameter for potential investors to assess whether it is reliable to bet on that business.
Calculating business profitability
To calculate the profitability of the company, just divide the profit obtained in a given period by the value of the initial invested capital.
There are different types of profitability index, which can be more assertive, depending on the need when performing the calculation.
The first step, essential to help calculate the different ratios, is to separate all the company’s financial statements. They will actually be the basis for the calculations to be done correctly.
When we talk about financial indicators, there is little care: it is necessary to carry out such calculations in detail.
In addition, thoroughness is also necessary when analyzing the data, since without proper interpretation, these indices will only be numbers.
See below which are the main indexes:
In this indicator there are two subdivisions: the return on assets index and the asset turnover index.
The return on assets index calculates profitability based only on investments made. To make this calculation, you need to multiply the net income by one hundred and then divide it by the asset value.
At the other end, the asset turnover ratio makes a relationship between net revenue and total assets, and to calculate it it is only necessary to divide between these two values.
The asset index (x) performs the calculation of the profitability of an asset, of the investment that was made, regardless of the source of funds. To calculate this ratio, multiply net income (LL) by 100, and then divide by asset value (AV).
The formula looks like this: x = (LL * 100) / VA .
Presented in two parts — operating margin and net margin — this process is defined as the amount the company is earning by selling its product or service.
The operating margin aims to measure the profit for each unit of product sold or service provided by the business.
When performing its calculation, however, the operating margin does not take into account expenses with expenses and taxes.
To arrive at the value of the operating margin, it is necessary to divide the profit obtained by the number of units sold, or even, by the number of times in which the type of service offered was sold.
The second margin mentioned is the net margin: the goal is to calculate the degree of net profitability that the company has. That is, this calculation is made after deducting all costs involved.
To arrive at this figure, multiply the net profit obtained by one hundred and divide it by net sales. Thus, the result indicates the net profit in each real of net revenue.
To calculate the operating margin (x), it is necessary to divide the operating profit (LO) by the number of units sold (UV).
the formula looks like this: x = LO / UV .
In the net margin, it is possible to carry out an evaluation of the profit, in a net way, that is, the profit that was generated, with the deduction of expenses.
Putting this into practice, the net margin index is an indicator responsible for demonstrating whether a company is being profitable and profitable.
To calculate the net margin (x), multiply the net profit (LL) by 100, and then divide it by the net sales (VL). The result obtained will be the net profit.
The formula looks like this: x = (LL * 100) / VL
Return on capital ratio
With this indicator, instead of dividing net income by assets, for example, it is necessary to use it by all equity.
This index is commonly used to show investors and new partners of the company how profitable the company has been and how safe it is to invest in the company.
It is one of the most required indexes by investors is the return on capital, which demonstrates whether the business is achieving the return on investment or is using the capital to remain active in the market.
To calculate this return, simply divide the net income (LL) by the company’s equity (PEL).
The formula looks like this: x = LL / PEL.
It is a term that can be translated as ‘return’, used to analyze the return on the initial investment of the business.
This indicator estimates the return time in which the company’s accumulated earnings will equal the initial investment.
In this way, the payback will give the manager an average period for the recovery of all the money invested in the business or project.
The term can be long or short, being measured in months or years, everything will depend on the amount invested, the type of business and the accumulation of income.
The payback calculation is directly linked to the cash flow, which, in turn, must be well designed and planned.
It should include all costs related to the investment, such as operating expenses, administrative expenses, equipment, employees, etc.
PB (Payback) = Initial investment / Average cash flow result
A company had an investment of 30,000.00 and the average result of its cash flow is 1,500.00, having a result:
Payback: 30,000 / 1,500 = 20 months
That is, approximately 20 months, giving a total of 1 year and 8 months.
Tips for calculating payback in a simple way:
- Raise the expenses and revenues of the company;
- Establish a fixed period for calculating the payback;
- Update the cash flow periodically;
- Monitor cash flow movement.
ROI (Return on Investment)
The ROI measures the income achieved with the invested resources: through it, it is possible to identify how much the company gained or lost with each investment made.
This helps to improve the business because you have a view of the panorama, allowing you to correct what didn’t work and optimize what went well.
Most small businesses generally do not adopt the practice of knowing how their ROI is , which makes it impossible for them to know whether the business is bringing the expected return, or in the worst case scenario, if it causes loss.
To calculate the ROI, just subtract the gain obtained by the initial investment, dividing this result by the initial investment.
The formula looks like this:
ROI = (gain obtained – initial investment) / initial investment
If the gain from a given investment was 80,000 and the initial investment amount was 20,000, for example. This means that the return achieved was 6 times greater than the initial investment.
The formula enables an analysis of the company’s investments, including in the marketing or tax area, for example. Which allows reviewing mistakes in the strategy, thus improving the company’s profit.
What do profitability ratios mean?
In order to have an answer to the main questions about a company’s profits, profitability indices cannot be analyzed in isolation.
In order to carry out a relevant assessment, it will be necessary to make a comparison with the return of other investments. Which can be a CDB or a savings account.
Even if the application has a lower risk when compared to the business. They serve as a parameter when assessing profitability.
It is important to bear in mind that an application with greater liquidity has a better chance of transforming the investment made into cash, unlike investments made in a company.
For the profitability index to be considered relevant. It needs to be double the average profitability of an investment considered conservative, such as bank savings.