It is necessary for companies to monitor their profitability ratios and take the initiative to use the Qoyod accounting system to help them calculate profit ratios periodically, because this is what helps them continue their work, achieve their goals, and maintain and develop the level of their services. How do companies benefit from calculating their profit ratios, and how are their profitability ratios considered indicators of problems in their operational plans? The article explains this in detail and provides simple examples to help understand how to calculate profit ratios for companies in various business fields.
Definition of profit ratios and profitability ratios in institutions
Profit is defined as the financial amount that a company earns from its trade in goods and services. To be able to say that your company has achieved profitability ratios, it must obtain revenues greater than the total expenses it incurred for production and getting the goods out to the customer. Therefore, calculating the profit ratio is a necessary process to determine the company’s financial performance.
Profit rate is a financial measure used to determine whether a company is profitable from its business operations or not by extracting its profitability ratios. This is achieved by conducting a simple accounting process that determines these ratios based on the net profit derived from total revenues.
To benefit from measuring your company’s profit ratio or profitability ratios, you must compare them to previous years’ profits, or to the profit ratios of competing companies operating in the same field, or even determine the best ratios between them and the company’s general average profits according to their areas of work.
The importance of profitability ratios
From the above, it is clear that calculating profit ratios in companies is of great necessity. Monitoring these ratios and determining whether they are trending upward or downward can help you make decisions that contribute to the following:
Developing investments in the company
When the results of measuring the company’s profitability ratios are announced, investors choose to invest in it, which contributes to developing its business, increasing its capital, and improving and developing the level of production in it. This process has excellent positive effects on the company’s business.
Identify the problems facing the company.
By measuring and calculating profit ratios, you can see more details related to the company’s activity, which helps you detect any problems facing the production, sales, or planning processes. Once these problems are identified, the relevant departments start formulating solutions to address and resolve them, while also devising innovative strategies to prevent them from recurring in the future.
Identify your strengths and weaknesses.
By comparing your company’s results with the results of competing companies, especially those with the same size and field as your company, you can determine your strengths and weaknesses. Understanding the strengths and weaknesses of your competitors enhances your capacity to seize opportunities and mitigate potential risks to your company’s operations, both now and in the future.
Determine the best activity seasons.
This advantage appears when comparing the results of your company’s profitability ratios during the current season and comparing them with the results of previous seasons. This gives you the opportunity to determine the best seasons for you, in which you expect a high profit ratio, so that you can properly direct your company’s resources and operational capabilities, exploit them, and improve returns through them.
Planning for liquidity banks
By calculating the profit ratios for your organization, you can strategically plan how to leverage these profits, whether it’s through new investments, the development of equipment to double your production capacity, or other avenues for company development, activity expansion, and business growth.
Types of profitability ratios
There are 3 basic types of profitability ratios in any company or commercial organization, and these types fall under other classifications for calculating the profit ratio, and we can explain this better as follows:
Return ratios
It is the first type of profitability ratio, defined as a measure of the ratio of profit to a company’s sales, or more clearly, a determination of the extent of the company’s ability to profit using strategies that contribute to it. Return ratios are divided into many classifications, including:
Return on assets ROA
This type of profit is known as return on assets and is concerned with determining the net profits that the company was able to achieve while linking them to the assets that the company uses to support sales operations and achieve gains. To calculate net profit, full expenses are subtracted from revenues, and then annual depreciation expenses are added to the result.
The formula for calculating return on assets = net income ÷ net assets
Return on equity (ROE).
Return on equity is another measure used to determine the extent of a company’s ability to profit from the shares owned by its shareholders and also determine whether it is a good destination for investment or not. This is done by determining the value of the paid-up capital and the proceeds resulting from the sale of the organization’s common shares, but this does not include the money that the company gains from the sale of preferred shares.
Returns on invested capital (ROIC).
Return on Invested Capital is useful if you want to measure the success of the way the company’s capital is used and exploited to achieve profits, as it is a more comprehensive measure than others because it depends on measuring all the investment income sources the company has. This return can be calculated based on the following equation:
Return on invested capital = net profit ÷ invested capital
Financial liquidity ratios
Although it is not a widely used measure, it is capable of determining whether or not the organization is able to convert its profits into financial liquidity. This type has two basic classifications, which are as follows:
Net cash flow ratio
By calculating this ratio, you can determine if your company requires additional financing, and consequently, this metric uncovers some of the company’s hidden issues. It is important to use it to avoid recurring negative liquidity ratios for long periods, even if the company is already achieving good returns, because recurring negative liquidity ratios mean that the company will lose at some point.
Liquidity margin
It means the financial flow that benefits the organization’s operational processes, and it is measured during a specific period and has a special equation through which it can be calculated, which is as follows:
Liquidity margin = (cash flow for operating expenses ÷ net revenues of the company) x 100
Profit margin ratios
A ratio that measures the company’s ability to manage its financial resources, including the assets and investments in them. This type of profitability ratio is widely used and has other classifications, including:
Gross profit margin
What is meant here is the company’s total revenues that came to it as a result of sales operations, and it extracts the value of expenses from revenues to find out how much profit the company was able to achieve. This measure also makes it easier to determine the company’s competitive ability and know whether its competitive advantage is limited to certain periods during the year or is normal and constant. You can arrive at the profit margin using the following equation:
Gross profit margin = (total revenues minus cost of products sold) ÷ revenues x 100
Operating profits
This measure is evidence that the company’s operations management is highly efficient, as it determines which expenses it can save without having a negative impact on its work and ability to provide its usual services. Its increase indicates that it can reduce fixed expenses, which contributes to improving returns, as well as enhance its revenues in general and profits in particular. The following equation can be used to calculate profit ratios for operational operations:
Operating profit margin = net sales minus (cost of goods sold plus selling, general, and administrative expenses) ÷ revenues achieved by the company during a specific period x 100
Net profit margin
It determines the number of net profits that the company was able to achieve by deducting all expenses incurred during the production and sales processes. It is commonly used thanks to its importance in controlling expenses within certain limits and determining whether the company needs to take new measures to confront any economic difficulties it faces. Net profit margin ratios can be calculated as follows:
Net profit margin = (revenues minus expenses) ÷ revenues x 100
EBITDA margin
A standard for determining the profit ratio during an organization’s fiscal year is to separate the profit from other expenses not related to the production process. If the margin ratio is high, this is good because it indicates large profits, and it has two different equations to calculate it, as follows:
First equation
EBITDA = (net income + interest + taxes + depreciation expenses) ÷ revenues x 100
The second equation
EBITDA = (Revenues – Cost of Goods Sold – Operating Expenses + Depreciation Expenses) ÷ Revenues x 100
Earnings before tax (EBT).
The company bears expenses in many channels, including operational and non-operating expenses and taxes, and when revenues come in, these expenses must be deducted from them in order to determine the true value of profits in the presence of taxes without deducting their value. This is the goal of determining the company’s real growth rate and making the danger points that may stumble clearly visible, which contributes to avoiding them and moving away from them. The following equation is used to determine pre-tax profits:
EBT = (Revenues with Taxes ÷ Total Revenues) x 100
Examples of calculating the profit ratio in different situations
Below, we provide you with simplified examples of calculating the profit ratio in Saudi companies or institutions that provide services for the purpose of profit, and these are the following examples:
First example
A company working in the production and sale of ready-made clothing needs to calculate the profit ratio during the year 2024. To determine its strengths and weaknesses compared to competitors, this can be done according to the following:
| Al Yusr Readymade Garments | |
| The company’s total revenues | 250 thousand riyals |
| The company’s net profit | 150 thousand riyals |
| Profit Ratio | 60% |
Second example
A restaurant that serves meals to customers’ needs to know the best seasons of activity for it to be able to exploit them correctly, so its profitability ratios must be measured, and this is done in the following way:
| Restaurant name: Al-Tabbakh for ready-to-eat meals | |
| Total revenue | 140 thousand riyals. |
| Net profit | 90 thousand riyals. |
| Profit Ratio | 64.2%. |
The equation used is Profit Ratio = (Net Profit ÷ Total Revenue) x 100.
= (90000 ÷ 140000) x 100 = 64.2%.
Third example
A home furniture selling company wants to attract new investments to expand its activity, and it must calculate profit rates for the fiscal year 2024 to ensure its readiness for that step. The details of its revenues were as follows:
| My house, Jannati Furniture and Furnishing Company | |
| Net profit for 2024 | 200 thousand riyals. |
| Total revenue for the year 2024 | 350 thousand riyals. |
| Profit Ratio | 57%. |
Using the equation (net profit ÷ total revenue) x 100, we find that
The company’s profit rate is 57%, which indicates that it is ready to receive new investments and grow the business.
How to calculate profit ratios in the Qoyod accounting system
The Qoyod accounting system contributes to calculating profit ratios in more than one way, relying on different accounting data, and gives you accurate results to decide the best next steps for your company. These methods include the following:
profit ratio of sales
Commercial companies need these types of metrics to measure their profits. Here is an example of how the profit ratio is calculated by looking at sales:
| If the profit is 75 thousand riyals,. |
| Total sales are 125 thousand riyals. |
| The profit ratio of sales = (profit ÷ total sales) x 100 |
| Profit ratio = (75,000 ÷ 125,000) x 100 = 60%. |
Profit margin on capital
People extract this ratio when they want to know the value of profits in relation to the capital expended, and then the profit ratios are calculated as follows:
| If the net profit is 200 thousand riyals and the value of the capital invested is 1,200,000, then the capital ratio is (net profit ÷ total capital) x 100. |
| Profit ratio = (200,000 ÷ 1,200,000) x 100 = 16.6% |
Profit ratio of a certain amount of money
If you have 15,000 riyals and decide to invest it in any profitable business and win 5,000 riyals, you can calculate the profit ratio for your project as follows:
| Profit ratio = profit ÷ amount invested x 100
Therefore, the profit ratio is (5000 ÷ 15000) x 100 = 33.3%. |
Conclusion
Qoyod accounting system experts are interested in the details of the process of calculating profit ratios for companies and commercial institutions in order to know the profitability ratios related to them, regardless of their areas of work and the markets they serve. These accounting processes contribute to improving the efficiency of the organizational and administrative work of institutions and help the Board of Directors make sound decisions, in addition to giving them the ability to confront any problems they may encounter in the future and to exploit the opportunities that are available to them. Therefore, you should take the initiative to try the Qoyod accounting system for free to obtain countless features and accurate and secure accounts without having to install it on your devices or enter your credit card information.
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