How is the profitability ratio calculated?

The profitability ratio is a key financial metric used to assess a company's ability to generate profit relative to its revenue. The correct method to calculate the profitability ratio, particularly when looking at it in its common form known as the profit margin, involves dividing net income by total revenue. This expresses how much of the revenue is converted into profit, providing valuable insight into a company's profitability.

When you take net income and divide it by total revenue, you arrive at a figure that indicates what portion of sales has turned into actual profit after all expenses have been accounted for. This ratio is crucial for assessing the financial health and operational efficiency of a business, making it easier for stakeholders to evaluate its performance over time or against competitors in the same industry.

The other calculations provided do not accurately reflect the concept of a profitability ratio. For instance, dividing total revenue by net income would yield a metric indicative of revenue efficiency rather than profitability. Similarly, looking at total assets divided by liabilities focuses more on financial leverage rather than profitability. Lastly, calculating gross revenue minus expenses gives a dollar amount but does not provide a ratio that can be easily compared across different firms or industry benchmarks.