Profitability index: what it is and how to calculate it, with examples

Do you really know how much profit your company generates?

Having a sense of that figure, or knowing what is left in the bank account at the end of each month, is very different from knowing your business’s profitability ratios.

But how do you calculate a company’s profitability? Which formulas should you use? How do you analyze your business’s profitability?

Every manager needs to know the company’s main financial indicators.

So before learning how to calculate the profitability index, it is worth getting an idea of the different kinds of ratios that exist.

In this post, you will learn the concept of the profitability index, the return indicators and how to calculate the company’s profitability.

Before going deeper, watch this video from our YouTube channelopens in a new tab. It covers other important financial indicators for your business:

Introduction to return and profitability ratios

It may seem like a superfluous matter, but in the company’s day-to-day routine you need to know the main profitability and return ratios and how they are measured.

Return ratios are among the most useful tools for good business management. They check the company’s ability to generate income, that is, to reward the invested capital.

The profitability index, on the other hand, helps you see whether the company is making a profit from the activity it carries out, that is, whether its profit relative to what it bills is adequate.

So the profitability index is calculated on the company’s total revenueopens in a new tab (in Portuguese), while return takes the investment into account.

Calculating a company’s return with these indicators is important for running the business properly and for convincing investors to fund new investments.

It is important to know these ratios and gain confidence in how they are calculated. Especially in dealings with banks, they are used very often and analyzed carefully.

Examples of profitability and return indicators

• Return on the capital invested in the company, ROI (Return on Investment);
• Return on the entrepreneur’s own capital, ROE (Return on Equity);
• Profitability of sales, the profitability index, also called net margin;
• Operating return on sales, ROS (Return on Sales), also called operating margin.

To calculate these ratios, the famous HP12C, the financial calculator favored by economists, is very handy.

What is the profitability index, anyway

The profitability index measures how much of the company’s net revenue turns into net profit. It is an important indicator, especially for comparing with companies in the same industry.

Before showing how to calculate it, it is worth knowing exactly what it means. Without that, there is no way to manage a company’s finances efficiently.

This index stands out because it gives a direct summary of how much you earn, in percentage terms, on each sale. That is why knowing how to calculate a company’s profitability matters so much.

If in my industry the average profitability index is 10% and my company has 3%, what does that mean?

It means there are critical issues to address to improve that ratio. They may be related, for example, to product pricing or production costs.

So we can use the following definition: the profitability index is the relationship between net profit and net revenue in a given period.

It therefore expresses the share of revenue that actually becomes profit for the company.

How to calculate the profitability index

The profitability index is calculated as the relationship between net profit and net revenue in a given period. It is also known as net margin.

It is easy to calculate using information from the financial statements: divide the year’s net profit by the year’s net revenue and multiply the result by 100.

Here is the profitability index formula:

Profitability index = (annual net profit / annual net revenue) x 100

The indicator can also be called the Net Profitability Index, because it uses net profit in the calculation.

Practical example of how to calculate the profitability index

To get to the result, you need full knowledge of your company’s numbers, as corporate performance management best practices recommend.

You need to know your annual revenue, that is, everything the company received during the year. You also need to know all operating and tax costs for the same year. To keep it simple, the example treats revenue as net revenue.

Imagine a company with annual revenue of R$ 200,000.00 and operating costs of R$ 120,000.00.

That means an operating result of R$ 80,000.00 per year. However, that is not yet the figure we need.

To get to net profit, you need to subtract the annual taxes from that amount. Let us assume they are R$ 40,000.00.

So we have a company with annual revenue of R$ 200,000.00 and net profit of R$ 40,000.00 (R$ 80,000 of operating result minus R$ 40,000 of taxes).

So the profitability index would be: (40,000 / 200,000) x 100

Profitability index = 20% per year

That means that, in the year analyzed, for every R$ 100.00 of sales the company earned R$ 20.00 in profit. It is an important number for knowing how efficient your company is compared with the competition.

How to calculate return indicators

To calculate return indicators, you need to calculate ROI (Return on Investment), ROE (Return on Equity) and ROS (Return on Sales).

As we saw, while profitability considers sales revenue, return looks at the investment in the business.

So you also need to learn how to calculate a return indicator. One of the best known and most used is ROI.

How to calculate ROI

ROI stands for Return on Investment. For a company, this return indicator can be calculated with the following formula:

Return = (net profit / investment) x 100

But for projects, when there is no net profit to look up in a balance sheet, use the following formula:

ROI = [(revenue − costs) / costs] x 100

An example of an ROI calculation for a project

The opening of a new store of a food franchise required an investment of 1 million reais.

The company’s finance executives estimated, at the time of the opening, that the store would pay back the investment in 3 years.

The store has average monthly revenue of 100 thousand reais, and its annual expenses are estimated at 840 thousand reais.

Did the finance department really get it right? What was the store’s return over 3 years?

Let us see:

• The franchise unit earned in 3 years: 3 x 12 x 100,000 = 3,600,000
• Costs in 3 years were: 3 x 840,000 = 2,520,000
• The initial investment was: 1,000,000
• So total costs were 1,000,000 + 2,520,000 = 3,520,000

Substituting in the return formula:

ROI = [(3,600,000 − 3,520,000) / 3,520,000] x 100

ROI = (80,000 / 3,520,000) x 100

ROI = 0.0227 x 100 = 2.27%

So yes: although the return is low, just above 2%, the franchise unit paid back the investment in its first 3 years of operation.

Now that the initial investment is paid back, the return is expected to keep growing.

How to calculate ROE

ROE stands for Return on Equity. It is also a return indicator. The ROE formula is:

ROE = (net profit / shareholders’ equity) x 100

To calculate this ratio, just check a company’s balance sheet or income statement and do the math.

Here is an example. Say a company has shareholders’ equity of 1 million 500 thousand reais and made a profit of 300 thousand reais.

Substituting in the formula, we get:

ROE = (300,000 / 1,500,000) x 100

ROE = 0.2 x 100

ROE = 20%

That is a high ROE, which indicates a good return on the company’s own capital.

How to calculate ROS

ROS stands for Return on Sales. Unlike the profitability index, ROS uses the operating result, before interest and taxes. The ROS formula is:

ROS = (operating result / net revenue) x 100

In the example company we calculated above, the operating result is R$ 80,000 and net revenue is R$ 200,000:

ROS = (80,000 / 200,000) x 100 = 40%

That is why ROS is higher than the profitability index when the company pays taxes and interest. Some materials use “ROS” as a synonym for the profitability index, so when comparing numbers, check which definition was used.

Is it now clear what profitability and return are? Then start using these indicators in your company.

Do you know how to create indicators for your business, financial or otherwise? Then watch this other video from our YouTube channel:

Another important financial tool is the annual company budget. Do you know how to build one? Download our free, ready-to-use spreadsheet: Complete Annual Company Budget Spreadsheetopens in a new tab (in Portuguese).

How to track financial indicators day to day?

Calculating the profitability index once a year shows the result but does not show the deviation in time to act. An indicator pays off when it is updated every period, compared with the target and followed by an action when it drifts from it.

In Stratwsopens in a new tab, the strategic and performance management platform created by Siteware, indicators live in a visual dashboard, with period-over-period comparison, and deviations are tracked through action plans until completion.

Visit our website and explore the Goal and Indicator Deployment solution in Stratwsopens in a new tab.