Profitability ratios: how much is earned, and on what
Profit on its own is a rupee amount. Profitability ratios ask how much was earned on each rupee of sales, and on each rupee of money put into the business. This lesson builds the margins and returns step by step, lets you change costs and borrowing, and shows why Info Edge's 35% margin sits beside a return on equity of 3%.
- Level
- Beginner
- Reading time
- About 25 minutes
- Know this first
- Liquidity ratios
By the end you will be able to:
- work out gross, operating and net margin and say what each one includes
- work out return on assets, return on equity and return on capital employed
- explain why the same profit gives a different return on assets, equity and capital employed
- say when a large investment portfolio or a one-off item distorts a return
Three margins, each after more costs
A margin is a profit divided by revenue. It answers "how much of each rupee of sales is left once these costs are paid". The income statement offers three natural stopping points, and each margin stops one step further down.
- Gross margin = (revenue − cost of goods) ÷ revenue. It is what is left after the direct cost of what was sold, and it has to pay for everything else.
- Operating margin = operating profit ÷ revenue. It is what is left after all the costs of running the business, before interest, tax and income from outside the main business.
- Net margin = profit after tax ÷ revenue. It is what is left for the owners once interest and tax are paid and other income has been added.
Titan's FY2023-24 shows the staircase. Revenue was ₹47,114 crore. After cost of goods, ₹10,172 crore remained, a gross margin of 21.6%. After employee, advertising, depreciation and other costs, operating profit was ₹4,577 crore, an operating margin of 9.7%. Other income of ₹510 crore and finance costs of ₹480 crore nearly cancelled, giving a profit before tax of ₹4,607 crore, and tax took the rest to a profit after tax of ₹3,544 crore, a net margin of 7.5%.
Move costs and borrowing, watch the margins and returns
A company has revenue of ₹10,00,000 and ₹10,00,000 of capital, part borrowed at 10% a year and the rest the owners' own money. Profit is taxed at 25%. Choose the cost of goods, the running costs and how much of the capital is borrowed. The left page is the year's profit and loss and the owners' share of the capital, and the right page shows the margins and the two returns that come next.
Of every 100 rupees of sales, 40.0 is left after the goods, 20.0 after running costs, and 12.0 after interest and tax. The business earns 20.0% on all the money in it (ROCE) and the owners earn 20.0% on theirs (ROE). ROE is higher than the after-tax return on the whole business because the borrowed money earns more than its 10% cost.
Three experiments. First, set borrowing to ₹0. The gross and operating margins do not move, and the net margin rises to 15.0% because there is no interest to pay, but ROE falls from 20.0% to 15.0%: with no debt the owners fund everything, and the company earns 20% on its capital before tax and 15% after. Second, set borrowing to ₹8,00,000. Operating profit is unchanged, yet ROE jumps to 45.0%, because the owners now put in only ₹2,00,000 and the company keeps whatever the borrowed money earns above its 10% cost. Third, push cost of goods to ₹7,00,000 and running costs to ₹2,50,000, so operating profit is just ₹50,000, and try both borrowing levels. Now the business earns 5% on its capital, less than the 10% interest, and borrowing makes ROE worse (1.3% with ₹4,00,000 of debt, 3.8% with none). Debt multiplies returns in both directions, and the next lesson on leverage returns to the risk.
Returns: profit set against the money behind it
Margins compare profit with sales. A return compares profit with the money invested in the business, and there are several choices of "money", because it depends on whose question you ask.
- Return on assets (ROA) = profit after tax ÷ total assets. It asks how much the whole asset base earned for the owners, however it was funded.
- Return on equity (ROE) = profit after tax ÷ equity. It asks what the owners earned on their own money.
- Return on capital employed (ROCE) = operating profit ÷ (total assets − current liabilities). It asks what the business earned, before interest and tax, on the long-term money in it, whoever supplied it.
The numerator and denominator are matched in each. ROE puts profit after interest over the money the owners supplied. ROCE puts profit before interest over the money both owners and lenders supplied. Mixing them, such as dividing operating profit by equity, gives a figure that answers no question.
Closing or average balances
Profit is earned across a year, but a balance sheet is a photograph on one day. Many analysts therefore divide by the average of the opening and closing balances, which is the textbook practice for returns. When only one balance sheet is available, the closing one is used. The two methods give different answers, and this lesson uses closing balances for both years so the two years are on the same footing. For FY2023-24 only, where the opening balance sheet exists, the average-balance results are given in the text.
The figures behind the ratios
These are the figures used. Titan is in ₹ crore and Info Edge in ₹ million, as printed, and the ratios do not depend on the unit. Capital employed is total assets less current liabilities.
| Figure | Titan FY2023-24, ₹ crore | Titan FY2022-23, ₹ crore | Info Edge FY2023-24, ₹ million | Info Edge FY2022-23, ₹ million |
|---|---|---|---|---|
| Revenue from operations | 47,114 | 38,270 | 23,809.58 | 21,586.19 |
| Gross profit (revenue − cost of goods) | 10,172 | 9,224 | n/a | n/a |
| Operating profit | 4,577 | 4,406 | 8,875.23 | 7,394.74 |
| Profit after tax | 3,544 | 3,333 | 8,330.82 | 4,111.93 |
| Total assets, closing | 32,862 | 25,088 | 295,348.18 | 129,141.90 |
| Equity, closing | 14,457 | 11,994 | 254,763.15 | 109,264.82 |
| Capital employed (total assets − current liabilities) | 19,500 | 13,567 | 281,097.67 | 116,351.21 |
| of which non-current investments | 6,178 | 1,116 | 248,916.66 | 91,260.21 |
Margins and returns for both companies
| Ratio | Titan FY2023-24 | Titan FY2022-23 | Info Edge FY2023-24 | Info Edge FY2022-23 |
|---|---|---|---|---|
| Gross margin: (revenue − cost of goods) ÷ revenue | 21.6% | 24.1% | n/a | n/a |
| Operating margin: operating profit ÷ revenue | 9.7% | 11.5% | 37.3% | 34.3% |
| Net margin: profit after tax ÷ revenue | 7.5% | 8.7% | 35.0% | 19.0% |
| Ratio | Titan FY2023-24 | Titan FY2022-23 | Info Edge FY2023-24 | Info Edge FY2022-23 |
|---|---|---|---|---|
| Return on assets: profit after tax ÷ total assets | 10.8% | 13.3% | 2.8% | 3.2% |
| Return on equity: profit after tax ÷ equity | 24.5% | 27.8% | 3.3% | 3.8% |
| Return on capital employed: operating profit ÷ (total assets − current liabilities) | 23.5% | 32.5% | 3.2% | 6.4% |
| The same, leaving non-current investments out of capital employed (an illustration) | 34.4% | 35.4% | 27.6% | 29.5% |
Titan: thinner margins, lower returns
Every Titan ratio in the tables fell between the two years. The gross margin slipped from 24.1% to 21.6%, the operating margin from 11.5% to 9.7%, and the net margin from 8.7% to 7.5%. The previous lesson showed the cause: cost of goods grew faster than revenue. The returns followed. Return on assets went from 13.3% to 10.8%, and return on equity from 27.8% to 24.5%. On average balances, FY2023-24 return on equity is 26.8% and return on assets is 12.2%, higher than the closing-balance figures because the balance sheet grew during the year and the average is smaller than the closing amount.
ROCE fell furthest, from 32.5% to 23.5%, and part of that fall is the denominator, not the profit. Capital employed rose by ₹5,933 crore, from ₹13,567 crore to ₹19,500 crore, and non-current investments rose by ₹5,062 crore, from ₹1,116 crore to ₹6,178 crore. The cash flow statement showed where that came from: Titan put money into investments in subsidiaries and other equity instruments during the year, and standalone operating profit does not include what those investments earn. If non-current investments are left out of capital employed, the same ratio is 34.4% against 35.4%, a much smaller fall. That is an illustration of how much of the decline sits in the denominator, not a measure Titan publishes. Its message is that an adjustment for something outside the trading business can change the story, so the reader needs to say which one is being used.
Info Edge: a 35% margin and a 3% return
Info Edge looks like a different world. Its operating margin was 37.3% and its net margin 35.0%, several times Titan's. Yet its return on equity was 3.3%, its return on assets 2.8% and its ROCE 3.2%, a fraction of Titan's. The explanation is in the balance sheet. Of total assets of ₹295,348.18 million, ₹248,916.66 million, or 84%, is non-current investments in other companies. Those investments are carried at fair value, and a gain of ₹157,101.44 million on them in FY2023-24 went through other comprehensive income straight into equity. Equity rose from ₹109,264.82 million to ₹254,763.15 million, a rise of 133.2%. The profit is earned by the services business, while the denominator is dominated by a portfolio of shares.
Put a profit from one source over a base from another and the ratio is a blend that describes neither. Leaving non-current investments out of capital employed gives 27.6% for FY2023-24 and 29.5% for the year before, a measure closer to how the services business earns on the money it needs. Again, this is arithmetic for illustration and not a company-published measure. It also does not value the investments, which are an important part of the company's worth. It shows that a low return can describe a balance sheet more than a business.
The net margin has its own wrinkle. It rose from 19.0% to 35.0%, but FY2022-23 carried an exceptional loss of ₹2,947.45 million and FY2023-24 included other income of ₹2,591.80 million, which the operating profit of ₹8,875.23 million leaves out. The operating margin, 34.3% to 37.3%, is the steadier guide to the services business. On average balances, FY2023-24 return on equity is 4.6% and return on assets 3.9%.
What profitability ratios cannot tell you
- Margins ignore the capital used. A high margin on a business that needs a lot of assets can still give a poor return. A thin margin on a business that turns its assets quickly can give a good one. The last lesson in this module, on DuPont analysis, joins the two.
- Returns depend on the balance sheet's accounting. Assets at cost, assets at fair value and fully depreciated assets give different denominators for the same business.
- One-off items. Exceptional losses and gains, tax changes and fair value movements can all move a margin or return in one year.
- They look backwards. A return earned last year does not promise one next year, and a new investment may not earn for several years.
- Definitions differ. Check whether a quoted ROCE or ROE uses closing or average balances and which profit it starts from.
Profitability across three business models
Margins say how much of each unit of revenue turns into profit, and returns say how much profit the owners' money and the company's assets produce. The table calculates both for Apple, Microsoft and Toyota from their latest statements. The returns use the average of the opening and closing balance sheets for the year, and the equity used is the equity attributable to the owners of the parent company.
| Latest year | Gross margin | Operating margin | Net margin | Return on assets | Return on equity |
|---|---|---|---|---|---|
| Apple | 46.9% | 32.0% | 26.9% | 30.9% | 171.4% |
| Microsoft | 68.8% | 45.6% | 36.1% | 18.0% | 33.3% |
| Toyota | 19.9% | 10.0% | 10.0% | 5.2% | 13.6% |
Toyota does not report a gross profit figure. The figure shown is revenue less its reported cost of sales, which includes the cost of its financial services business, and it should be read as a guide only.
The ordering is the same on every measure: Microsoft has the widest margins, Apple the highest returns on assets and equity, and Toyota the lowest of each. That is a fact about each business model and not about quality. A car maker with plants, dealers and a lending arm will always show lower margins and returns on assets than a software and services company, and it is only reasonable to compare Toyota with other car makers.
Apple's return on equity of 171.4%
Apple's return on equity is 171.4%, five times Microsoft's 33.3% even though Microsoft's margins are higher. The reason is in the denominator. Equity averaged $65,342 million over the year, from $56,950 million to $73,733 million, small beside net income of $112,010 million, because Apple has spent years returning more cash to shareholders than it earns. In the latest year it repurchased $90,711 million of its own shares. Buybacks shrink equity, and a smaller equity base makes the same profit look like a larger return. The return on assets, 30.9%, is a better guide to how productive the business is, and next to it Microsoft's 18.0% looks respectable.
Return on equity can therefore rise because a business improves, or because it has shrunk its equity, or because it has borrowed more. The lesson on DuPont analysis separates those three.
Rulebooks reach profitability too
Return ratios depend on how assets and equity are measured, and the rules differ. Under IFRS, development costs that meet six criteria are recorded as an asset, while US GAAP generally expenses research and development. A company that capitalises such costs shows higher assets and equity and, in the early years, higher profit. IFRS also requires impairment losses on most assets to be reversed if conditions improve, while US GAAP prohibits it, so the same event can leave different assets on the balance sheet years later. Comparing a return on equity between companies using different standards is therefore a first approximation. A closer comparison adjusts for the largest differences, which the notes allow you to estimate.
Common mistakes
Mixing numerator and denominator
Operating profit belongs over capital that includes borrowed money. Profit after tax belongs over equity. A mismatch gives a figure with no meaning.
Reading ROE without looking at debt
The lab showed ROE rising from 15.0% to 45.0% purely because the owners put less in. A high ROE can reflect borrowing as much as skill.
Comparing returns across firms with different balance sheets
Titan's 24.5% and Info Edge's 3.3% differ largely because of what each holds on its balance sheet, not only how well each trades.
Taking a single margin as the whole story
Info Edge's net margin jumped from 19.0% to 35.0%, while the operating margin moved from 34.3% to 37.3%. Look at all the rungs.
Comparing closing-balance and average-balance returns
Titan's FY2023-24 ROE is 24.5% on closing equity and 26.8% on average equity. Both are valid. Putting one beside the other is not.
Try it yourself
1. A shop has revenue of ₹50 lakh, cost of goods of ₹30 lakh, running costs of ₹10 lakh, interest of ₹2 lakh and tax of ₹2 lakh. Work out the three margins.
Show the working
Gross profit is 50 − 30 = 20, so gross margin is 20 ÷ 50 = 40%. Operating profit is 20 − 10 = 10, so operating margin is 10 ÷ 50 = 20%. Profit before tax is 10 − 2 = 8, and profit after tax is 8 − 2 = 6, so net margin is 6 ÷ 50 = 12%.
2. A company earns a profit after tax of ₹6 lakh. Its equity is ₹30 lakh and its total assets are ₹50 lakh. Work out ROE and ROA, and say why ROE is higher.
Show the working
ROE = 6 ÷ 30 = 20%. ROA = 6 ÷ 50 = 12%. ROE is higher because part of the assets, ₹20 lakh, is funded by liabilities. The owners supplied only 60% of the assets but receive the profit.
3. Titan's operating profit was ₹4,577 crore and its capital employed ₹19,500 crore. Work out ROCE. Capital employed rose by ₹5,933 crore in the year, and non-current investments by ₹5,062 crore. What does that suggest about the fall in ROCE?
Show the working
4,577 ÷ 19,500 = 23.5%. Most of the growth in capital employed came from investments whose earnings are not in operating profit, so part of the fall is the denominator growing. Leaving non-current investments out gives 34.4% against 35.4% a year before.
4. Info Edge has a net margin of 35.0% and a return on equity of 3.3%. What explains the gap?
Show the working
Equity of ₹254,763.15 million is large because it includes the fair value gain on investments in other companies, which are 84% of total assets. The profit is earned by the services business, while the denominator is dominated by an investment portfolio.
Where this is used
- A shareholder compares ROE across several years to see whether management earns a steady return on the money entrusted to it.
- A manager tracks the gross margin by product line to find where pricing or purchase costs are slipping.
- A lender uses ROCE to judge whether the business earns more than it pays for borrowed money.
- An analyst adjusts capital employed for investments held outside the trading business before comparing two companies.
Key terms
- Gross margin
- Revenue less cost of goods, as a share of revenue.
- Operating margin
- Operating profit as a share of revenue. Here, profit before finance costs, with other income left out.
- Net margin
- Profit after tax as a share of revenue.
- Return on assets
- Profit after tax divided by total assets.
- Return on equity
- Profit after tax divided by shareholders' equity.
- Capital employed
- Total assets less current liabilities: the long-term money in the business, from owners and lenders.
- Return on capital employed
- Operating profit divided by capital employed.
- Average balance
- The mean of the opening and closing balance sheet figures, used because profit is earned across the year.
Questions people ask
What is a good profit margin?
It depends on the industry. A business with high stock and thin pricing may have a net margin of a few per cent, and a software business can have many times that. Compare with similar firms and with the company's own history.
Which return is best?
None is best for every question. ROE is for owners, ROA for the whole asset base, and ROCE for the earning power of the business before the way it is funded. Read them together.
Why do websites quote different ROE figures for the same company?
Closing versus average equity, consolidated versus standalone statements, and profit before or after exceptional items are the usual reasons. The formulas in this lesson are stated in full so you can repeat them.
Can ROE be too high?
It can be if it is high because equity is small relative to debt, since that raises the risk to the owners. The next lesson covers debt directly.
Sources and review
- Titan Company Limited, audited standalone and consolidated financial results for the year ended 31 March 2024, filed with BSE. Source of every Titan figure.
- Titan Company Limited, audited results with statements of cash flows for the year ended 31 March 2024, filed with BSE. Source of the investment lines mentioned.
- Info Edge (India) Limited, audited standalone financial statements, Q4 FY24. Source of every Info Edge figure.
- CPA British Columbia, Financial ratio analysis (guidance), for the operating margin formula and the practice of dividing an income statement figure by an average balance sheet amount.
- Lumen Learning, Financial Statement Analysis Defined, for profitability as one of the four families of ratio.
- Apple Inc., Form 8-K, Exhibit 99.1: fourth quarter and full-year fiscal 2025 results, filed with the US Securities and Exchange Commission. Source of Apple's statements.
- Microsoft Corporation, Form 8-K, Exhibit 99.1: fourth quarter and fiscal year 2025 results, filed with the US Securities and Exchange Commission. Source of Microsoft's statements.
- Toyota Motor Corporation, FY2025 Financial Summary (IFRS, unaudited, in millions of yen), furnished to the US Securities and Exchange Commission on Form 6-K. Source of Toyota's statements.
- PwC, IFRS and US GAAP: Similarities and differences, internally developed intangible assets, for research and development costs.
- Deloitte, Roadmap: IFRS and US GAAP comparison, 1.7 Impairment of nonfinancial assets, for the impairment tests and the reversal of losses.
How the numbers were checked: both companies' statements were rebuilt from the printed lines and every subtotal matched the filing. Operating profit was computed two ways and agreed. Every margin and return was recomputed in code from those figures, and the statements in the text, such as the change in capital employed and the share of investments in total assets, were asserted before the page could build. The calculator was tested against separate arithmetic across thousands of slider combinations.