What are Profitability Ratios?

Profitability ratios are values used to rank the likelihood that an investment will be a profitable venture for an investor. These ratios are determined using a calculation that compares the capital requested for an investment with the current value of the investment. For stockholders, profitability ratios are estimates of the likelihood that a company will make profits in the future. The profitability ratio is used to predict whether a stockholder can expect to see profits on a stock investment.

Just one method used in a system designed to help investors choose good opportunities, profitability ratios are used to rank potential investments within a profitability index (PI), which is a grading system ranking investments by their anticipated ability to return a profit. The formula used to determine PI can vary, but the calculation is based on an equation in which the present value (PV) of an investment opportunity is divided by the investment required. Usually, investors regard a ratio of less than one to be a poor investment prospect. Finance professionals use profitability ratios within PI lists as a means of predicting future revenue streams as part of a method called discounted cash flow (DCF), a system used to determine whether an investment is a sensible financial idea.

When investors use DCF to determine the potential of an investment, they look at the profitability ratios in the PI, but they also consider other cash flow predictions for the investment to make an overall determination of whether it is an overall beneficial place to invest money. Cash inflow plays a big part in calculating the potential return on an investment. A combination of the operations, sales, cash on hand, and investment returns held and received by a company, cash inflow basically tallies up all of the money that is coming in. Companies and investment organizations use DCF as part of the planning process that determines where they will spend the capital held by the organization.

Present value (PV) is a measurement of the current value of an investment, used to determine the time value of money, or what the money would likely be worth at a different time. When an investment arrangement involves a future payout, the PV estimates what an investment would be worth in the present using the assigned interest rates for the period of the investment. Essentially, the PV tells the investor what they would have to put into an interest-bearing account today to receive the same payout as the proposed investment. If a businessperson seeking capital wants more investment money than an investor could make by putting the money into an interest-bearing investment opportunity, the business opportunity is not projected to be a worthwhile venture.