Profitability percentage formula: the meaning and explanation with example

Profitability percentage formula (or profitability) is a financial ratio that indicates how much a company earns from its assets. The English term for this is return on assets (ROA), which is why another Dutch term with the same abbreviation has become popular. You calculate the return on assets in the same way as the profitability. You calculate the profitability on the equity, the total capital or the loan capital. The number allows you to calculate the return on capital. It is used to make investment decisions. The higher the profitability, the higher the return on investment. Investments with a higher profitability are therefore often given priority when choices have to be made. In this article you will find more information about the meaning of profitability and how profitability can be calculated.

The following profitability percentage formula topics are discussed:

  • Profitability meaning
  • Profitability percentage formula: 3 formulas
  • Example of calculation of return on capital
  • What is a good return on assets?

Profitability percentage formula meaning

Profitability is a key figure that provides insight into the revenues of a company. The word profitability refers to the return that a company makes and has nothing to do with interest. The calculation shows the ratio between the income and assets of a company.

There are three ways to define the assets:

  1. Possessions you invested yourself, the equity.
  2. The assets you borrowed, the foreign assets.
  3. Total equity, equity plus debt.

Profitability percentage formula: 3 formulas

The three ways therefore provide three different ways to calculate profitability. The return on equity, in English return on equity (ROE) is calculated as follows:

Return on equity = (net profit / average equity) * 100%

For providers of loan capital, the return on invested capital is calculated as follows:

Return on loan capital = (interest paid / average loan capital) * 100%

The return on assets is as follows. Make sure that you do not forget the proceeds for the tax authorities:

return on assets = ((net profit + interest + taxes) / average total assets) * 100%

Another way to calculate the return on assets ratio of total capital is to divide earnings before interest and tax ( EBIT ) by the average total capital.

Example of Profitability percentage formula of return on capital

Step 1 : Suppose a company makes ₹ 100,000 net profit. Loans cost the company ₹ 20,000. Finally, the company pays ₹ 30,000 in taxes.

Suppose you want to calculate the return on equity, then you only take the net profit. If you want to calculate the return on the total assets, you have to add the amounts together and you arrive at ₹ 150,000.

Step 2 : Now that the income is known, you have to divide the income by the average assets. This company has debt of ₹ 400,000 and equity capital of ₹550,000 at the beginning of the year. The borrowed capital will remain the same, but the equity will increase to ₹ 650,000 in the course of the year. The average equity capital is therefore ₹ 600,000 ((₹ 550,000 + ₹ 650,000) / 2). The average total assets are ₹ 1,000,000.

Step 3 : Use the different profitability percentage formula to calculate profitability.

For example, if you want to calculate the return on assets, this works as follows: (₹ 150,000 / ₹1,000,000) * 100% = 15%.
The return on equity is: (₹ 100,000 / ₹ 600,000) * 100% = 16.67%.
Finally, the return on loan capital: (₹ 20,000 / ₹ 400,000) * 100% = 5%

What is a good return on assets?

The profitability standard to pursue differs per company. In general, it can be said that a higher return on assets is better.

Yet this also has a disadvantage: striving for too high returns can cause you to not carry out good projects because they are not profitable enough. The right return to pursue depends a lot on the risks of the business. In addition, it is of course important to see what profitability will be calculated. In general, the risk of loans is lower, which means that loan capital also has a lower return on capital.

Other key figures

It is important for investors and investors to know what an investment will yield. In order to calculate this return in the long term, Profitability percentage formula are useful. Useful additions to look at are EBITDA and EBIT.  These key figures provide a picture of profitability and take into account depreciation, taxes and interest costs. However, it is also important to know whether a company can continue to exist in the shorter term. For example, it may take a long time for investments to yield anything. To estimate these types of concerns, it can be useful to look at liquidity and solvency .

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