Who uses profitability ratios and why is it important?

28.05.2020
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Introduction

In a different blog, we have already discussed the meaning and types of profitability ratios. However, it is imperative to understand the importance of these ratios for an insurance company. Profitability ratios of an insurance company allow the insurance company to measure its profitability against its revenue, cost of sales, equity, and balance sheet assets. Profitability ratios are also related to efficiency ratios as they show how well companies are using their assets to generate profits. In this blog, we will discuss the importance of different profitability ratios and how are they used by investors and creditors to measure a company’s operating profit and judge its return on investment.

Importance of profitability ratios:

Here, we will discuss the significance of different profitability ratios that are considered by investors and creditors when judging the operating profits of an insurance company:

  • Gross profit margin, a profitability ratio that is used to measure the profits earned by an insurance company on its sales. It calculates the profit part of the total revenue earned after deducting the costs of goods sold. Gross profit margin is significantly important since it covers the total office costs including the admin cost and dividends to be distributed to the shareholders of the company. It is also used to evaluate the efficiency of cost management. The higher the gross margin ratio the more profitable the corporation is and is also a good catch to invest in.
  • The net profit margin is the final profitability ratio that confirms the overall performance of an insurance company. We may also say that this ratio is the most important profitability ratio for management since fluctuation in any ratio directly hit the net profit margin as well. For example, a low gross profit margin ratio may be because of low sales which would obviously lower the net profit margin.
  • The net profit margin is an important metric for the company itself whereas the return on equity(ROE) is the most important ratio for the investors. The ROE of a company is a percentage of the earnings that shareholders get in return for the money invested in the company. The higher the ROE implies higher dividends the shareholders will receive that will attract more investors.
  • One other profitability ratio is ROCE(return on capital employed) that measures the efficiency of the company to use its assets. It is also an important profitability ratio as it helps the company to minimize inefficiencies by evaluating the extra expenses. The higher the ROCE of an insurance company as compared to other companies, the higher the efficiency of the production process of the company.
  • Return on assets(ROA) is a profitability ratio that measures the net income earned on total assets owned by the company. This profitability ratio is much similar to ROCE and helps a company to manage the utilization of its assets. Before investing in a company, an investor or a creditor may look at ROA as the return on investment for the company.
  • EBITDA(earnings before interest, taxes, depreciation, and amortization) is a measure to calculate the company’s overall financial performance. However, there is no legal requirement for companies to disclose their EBITDA. This profitability ratio is generally used by a company to compare its year to year financial performance.

Let us take an example to calculate the profitability ratios for a company called ABC limited. ABC Limited is an insurance agency with $160,000 in total net sales along with the following expenses.

Below is the data table of expenses and different profitability ratios for the ABC limited company:

Sr. no. A Formulas B (in $)
1. Net Sales (+)160,000
2. Cost of goods sold(insurance claim paid) (-)70,000
3. Salary expense (-)10,000
4. Interest expense (-)10,000
5. Other expenses (-)25000
6. Taxes (-)4,000
7. Net income =B1-(B2+B3+B4+B5+B6) 41,000
8. Gross profit =B1-B2 90,000
9. Gross profit margin =(Gross profit/ Net sales) * 100 56.25(%)
10. Net profit margin =(Net income/Net sales)* 100 25.62(%)
11. EBITDA =B1-(B2+B3+B4+B5) 45,000
12. EBITDA Margin =(EBITDA/Net sales)*100 28.12(%)

What is Gross Profit Margin?

Gross profit margin, a profitability ratio that is used to measure the profits earned by an insurance company on its sales. It calculates the profit part of the total revenue earned after deducting the costs of goods sold.

How is net profit margin important?

The net profit margin is the final profitability ratio that confirms the overall performance of an insurance company. We may also say that this ratio is the most important profitability ratio for management since fluctuation in any ratio directly hit the net profit margin as well.

What is ROCE?

One other profitability ratio is ROCE(return on capital employed) that measures the efficiency of the company to use its assets. It is also an important profitability ratio as it helps the company to minimize inefficiencies by evaluating the extra expenses.

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