Limitation of Profitability Ratio
Profitability ratios are the financial ratios that use to evaluate the company’s ability to generate return from the available assets and equity investments.
Investors always analyze the company before making a new investment. They want to know the estimated earnings in advance.
Investors are willing to invest in a company that can generate a high return. They are looking to compare the earnings of one company to another.
By using the same ratios, the investors can compare the performance of one company to another. The strong company will be able to generate higher returns compared to a low-performance company.
At the same time, it allows the management to access the company performance and compare it with the industry average. It will show the weakness that company has to improve to increase earnings. Even though our company is growing, it may still have room for improvement if the industry growth is higher.
A profitability ratio is a set of ratios that we use to estimate the company performance. Even though they are very useful for business analysis, they also have some limitations. We have to be aware of these limitations and avoid heavily relying on such ratios. We have to gather information from other sources to support our decision.
Profitability Ratio Formula
There are many profitability ratios used to evaluate the company’s performance. Please refer to the following explanation.
Contribution Margin Ratio
Contribution Margin Ratio = (Sales – Variable Expense)/Sales
This ratio measures the contribution over the sale generated. It measures the company’s ability to use the contribution to pay for the fixed cost and the remaining profit.
A high contribution margin shows the company’s strong ability to pay off the fixed cost and remain as net income.
A low ratio shows the high risk that the company is facing. They are challenging to pay for the fixed cost if a slightly reduce in the company sales.
In any situation, the ratio must be positive. It means the company must have some portion remaining to settle the operating expense. If the ratio is negative, it means the company sells for less than the variable cost. So they should stop the operation.
Net Profit Ratio
Net profit ratio = Net profit / Sales
This ratio measure the company’s ability to generate net profit compare to the sale generated. It shows the remaining percentage after deducting all costs and expenses during one accounting period. It is the deduction of all expenses including cost of goods sold, salary expense, income tax expense, finance cost, and other operating expenses.
If the ratio is too low, it shows the risk of failure for the company when a variable changes. For example, the increase in any expense or the reduction in sales will have a significant impact on the company’s profit.
Return on Assets
Return on Assets = Net Profit / Total Assets
This ratio measure the company ability to generate profit from the total assets own. It measures the company efficiency in using the available assets to generate profit.
The return on assets can tell us the expected profit if the company increases the assets through debt or equity.
The investors will take a closer look at this ratio when they want to invest in the company. They will compare the ratio with the industry average or the competitors.
Return on Equity
Return on Equity = Net Profit / Equity
This ratio measure the company return generate from the capital invested by shareholders. It shows the return that investors can receive after investing a certain amount into the company.
Limitation of Profitability Ratio
- The contribution margin ratio does not take into account the bottleneck in the production process. Not all production and variable costs will increase in the perfect liner graph.
- The Net profit margin is the measurement of the company’s short-term goal only. It will be a problem if the company is investing heavily in the long-term plan which will not be able to generate profit immediately.
- Some companies intend to low down the net profit margin in order to increase the market share which will benefit them in the long run. They may be able to sell the related product which can increase the combined profit.
- The return on assets has several limitations such as:
- Seasonal business: the net profit can fluctuate due to the seasonal business.
- Depreciation: The value of assets can vary due to the depreciation method, so it leads to the difference in ratio as well. Similar companies will generate two different ratios if they use two depreciation methods such as straight-line and double-declining.
- Manipulation: most of the ratios here rely on the company’s profit which is easily manipulated. The managers can manage the company’s profit through the accounting estimate, accounting policy, and so on. So it is hard to rely on such ratios based on these factors.