When it comes to performing profitability analysis, profitability ratios are typically the first tool deployed. These financial metrics are relied on heavily to understand how efficient a business is at generating profits and driving shareholder value. Profitability ratios are often viewed through the lens of the industries they operate within, so understanding the basics behind them will help you apply them in the most meaningful way.
In this FAQ we will discuss what profitability ratios are, why they are important, how they are used, and some of the more common ratios.
What Are Profitability Ratios?
Profitability ratios are metrics that provide insight into how efficiently a business can generate profits. They examine revenue in relation to operating costs, balance sheet assets, or equity to assess the business’s ability to create profits.
These financial metrics are comparable to efficiency ratios, which examine how well a business can use its assets to create income. The difference between the two ratios is that efficiency ratios examine the business’s ability to generate revenue, whereas profitability ratios examine the business’s ability to generate profits.
Why Are Profitability Ratios Important?
Profitability ratios convey important information that gives a comprehensive view of how well a business is at utilizing its assets and equity to drive profits. At the same time, it provides insight into how well a business is managing its operating costs as well.
They are some of the most widely used financial metrics because they provide insight from various perspectives. The ratios are used as an indicator of how good a business is at converting sales to profits and generating returns on assets and equity.
How Are Profitability Ratios Used
While the mathematics behind the ratios are fairly simple and straightforward it is important to note that the metrics must be viewed with some sort of context. Therefore, they are commonly compared against industry standards to provide a more accurate picture of the business.
For example, certain industries like retail are subject to seasonality impacts. This means comparing first quarter and fourth quarter profitability ratios would be less helpful than examining fourth-quarter results against the industry averages.
This means that profitability ratios are their most helpful and provide the most value when they are compared to the ratios of similar businesses, historical results, and industry averages.
Three Common Profitability Ratios
While there are many profitability ratios, there are three common metrics that most analysts consistently rely on. Each provides a different perspective and when viewed together can paint a somewhat complete picture of the business’s ability to generate profit.
Profit margin compares profitability at different levels of costs. These include gross margin, operating margin, Earnings Before Taxes (EBT), and Net Income or net profit. As each additional layer of costs is included, the ratio becomes smaller.
Gross profit margin examines how much a business makes after taking into consideration the costs of goods sold. The formula for calculating gross profit margin is:
Gross Profit Margin =Total Revenue COGS
Operating Profit Margin is the ratio of operating income to revenue. The formula for calculating operating profit margin is:
Operating Profit Margin=EBITTotal Revenue
EBT Margin, or margin on earnings before taxes, examines profitability prior to the impact of taxation. The formula for calculating EBT Margin is:
EBT Margin=EBTTotal Revenue
Finally, net income margin or net profit margin is the ratio of net profit to total revenue. The formula for calculating net profit margin is:
Net Profit Margin=Net IncomeTotal Revenue
Return On Assets (ROA)
Return on assets is a way of monitoring how well the business is utilizing its assets to drive net income. As the name implies, the metric is concerned predominantly with identifying how much net income is being created with the assets owned by the business. The idea is that the more assets the business has, the more sales and profit potential it creates.
This is because as businesses accumulate more assets, they should be creating more economies of scale that help to reduce cost and therefore increase margins.
The formula for calculating return on assets is:
ROA=Net IncomeTotal Assets
Return On Equity (ROE)
Return on equity is a ratio that measures the return generated as the result of equity investments in the business. ROE is an indicator of the value created as a result of equity contributions made by shareholders.
One of the considerations of ROE is that it can also indicate how well the business is utilizing its assets and debt to create shareholder value. This is because ROE can increase without additional equity investments and instead grows as a result of rising net income driven by a larger asset base and efficient debt utilization.
The formula for calculation ROE is:
ROE=Net IncomeShareholder Equity
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