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.
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
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
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.
The ratio suffers from the following flaws:
- It includes items that do not relate to the core operations of the business, such as interest income and expense. For example, a financing gain could mask an operating loss.
- It does 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.
- 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.
The profit ratio is sometimes confused with the gross profit margin 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.
