Profitability is an earned profit after you exclude all operating costs and expenses. In simple words, the profitability ratio helps investors determine if a company makes a decent amount of profit from its business and operations. Of course, the higher profitability ratio results are always better performance indicators. Still, these ratios need to be compared to results of similar companies, the company’s historical performance, or the industry average.
Types of Profitability Ratios
Several profitability ratios are used in identifying a company’s performance such as gross profit margin (GPM), operating profit margin (OPM), return on sales (ROS), return on assets (ROA), return on equity (ROE), and return on investment (ROI).
This article will explain two fundamental profit metrics: Profit margin (PM) and operating profit margin (OPM).
What Is Profit Margin?
Profit margin is the percentage of sales that the company retains after all expenses have been deducted. The profit margin is calculated by subtracting total expenses from revenue, then dividing by revenue. When comparing similar companies and their profit margins, a higher profit margin can mean the company is good at keeping costs low.
Profit Margin= (Revenue – Costs) / Revenue
If a company’s $100,000 profit reflects a 50% profit margin, we can say that the company is financially healthy. If that $100,000 is a mere 1% over the company’s overall operating expenses, then the company may go into bankruptcy with a slight increase in costs.
What Is Operating Profit Margin?
Operating profit margin is a profitability ratio that represents the percentage of profit generated by a company’s operations before taxes and interest charges are deducted. You can calculate the operating profit margin by dividing the operating income by total revenue and making it as a percentage.
Operating Profit Margin= Operating Income/ Total Revenue
Operating income takes into account operating expenses including salary, marketing costs, depreciation, facility costs, transportation costs, and equipment. For this reason, people often call operating profit margin as earnings before interest and tax (EBIT). Indeed, high operating profit margins mean the company can pay for fixed costs and interest on obligations. Moreover, companies with high operating profits can overcome an economic slowdown easily.
To read more about Islamic Finance related topics, please click here and visit our academy.
Besides, feel free to sign up for our free stock screening services at musaffa.com.