Also known as profit margin, the profit ratio is simply the net profits that remain after taxes are calculated and settled, divided by the sales or the revenues generated for the same period. The idea behind this type of ratio or margin is to determine the percentage of revenue that is actually kept as earnings when all related expenses have been accounted for and paid in full. Typically, a business will calculate a profit ratio for twelve-month period, although in some industries it is common for this type of calculation to occur on a quarterly as well as an annual basis.
In order to begin the process of determining the profit ratio, it is first necessary to arrive at the net profit that serves as the basis for the calculation. Essentially, net profit is simply what is left after all relevant expenses have been deducted from the gross profit generated for the period under consideration. What constitutes net profit varies somewhat from one country to the next, with some businesses focusing on actual production expenses while omitting administrative expenses. In other scenarios, any expenses related to the operation of the business are deducted from the gross profits. With either approach, taxes are also deducted, leaving an amount that is often referred to as net profit after taxes.
Once the net profit is established, this figure is divided by the sales generated for the same period. In some situations, businesses prefer to go with collected revenues rather than actual sales, since some of the sales made during the period may not have been collected at that point. The resulting figure is usually shown as a percentage. A higher percentage means that the business keeps more of the net profit generated, while a lower percentage confirms that the business is not keeping a great deal of the net profits that were realized during the period under consideration.
What constitutes an acceptable level of profit ratio will vary from one setting to another. For example, a 20% ratio may be considered reasonable in one industry, but be considered extremely low in another. Even when the profit ratio is considered favorable, it is not unusual for business owners and key members of the management team to analyze the costs associated with the production process, looking for ways to trim those costs and increase the amount of net profit realized in the upcoming period. Assuming that this can be accomplished without having a negative impact on the sales or revenue generated during that time, the implementation of any new cost cutting strategies is likely to result in improving the profit ratio.