Profitability ratios are used by financial analysts to assess a company’s ability to generate earnings relative to its revenues for a period. It signals how efficiently the company has managed to generate profit and value for its shareholders.
Company’s ability to generate profits on capital invested is the most important factor in order to find out its value and the value of the securities it issues.
Income statement of a company shows you the sources of earnings and components of revenue and expenses.
Here is the list of commonly used profitability ratios by analysts;
|Return on sales
|Gross profit margin
|Operating profit margin
|Operating income/ revenue
|Net profit margin
|Net income/ revenue
|Return on investment
|Operating income / Average total assets
|Return on Assets (ROA)
|Net income / Average total assets
|Return on total capital
|EBIT / Short and long term debt and equity
|Return on Equity (ROE)
|Net income / Average total equity
|Return on common equity
|(Net income – Preferred dividends) / Average common equity
What do these profit margins indicate?
Gross profit margin of a company indicates the percentage of sales available to cover operating and other costs.
Higher gross profit margin indicates that the company has a competitive advantage in product costs.
Operating profit margin is calculated by dividing operating profit of a company by revenue. Operating profit is the amount left out after taking out operating expenses such as administrative overhead from gross profit.
A higher operating profit margin indicates good control over operating expenses. In contrast, a declining operating profit margin indicates deteriorating control over operating costs.
Net profit margin indicates how much money as a percentage of sales, the company is able to retain after incurring all expenses to generate revenue. Net profit is calculated as revenue minus all expenses.
Higher value relative to a competitor’s ratio or relative to previous periods indicate that the company is doing well.
These three profit margins are referred to as “return on sales” as these are calculated on total sales of the company.
Return on investments
Return on investments or assets is a measure to know how efficiently the company has used company’s assets in order to make profit. In other words, it tells how much the company earned by on its assets.
Total assets of a company are funded by both debt and equity capital. Therefore if the company has debt in its capital, then you need to add back interest to calculate return on investments.
In this case the formula can be rewritten as follows;
Net income + Interest expense ( 1-Tax rate ) / Average total assets
Return on capital
Return on capital measures the profit a company earned on all of the capital that it employs, which includes short term debt, long term debt and equity. In this case profit before interest and tax should be considered for calculation.
In order to calculate the rate of return a company earns on equity capital, we have to divide net income after tax by the equity capital of the company.
Both Return On Assets (ROA) and Return On Equity (ROE) are important measures of profitability.
These financial ratios will give you much more information when compared to results of similar companies. Margin ratios such as net profit margin and operating margin indicates a company’s ability to turn sales into a profit. Return ratio offers different ways to examine how well a company generates a return for its shareholders.