Profitability ratios show how much profit the company takes in for every dollar of sales or revenues. They are used to assess a business's ability to generate earnings as compared to expenses over a specified time period (Figure 1).
Profitability ratios are going to vary from industry to industry, so comparisons should be between other companies in the same field. When comparing companies in the same industry, the company with the higher profit margin is able to sell at a higher price or lower expenses. They tend to be more attractive to investors.
Net Profit Margins and Returns on Sales
Many analysts focus on net profit margins or returns on sales, which are calculated by taking the net income after taxes and dividing by the revenues or sales. This ratio uses the bottom line on the income statement to calculate profit for every dollar of sales or revenues. The operating margin takes the profit before taxes further up the income statement and divides by revenues. Operating margins are also important, since they focus on the operating income and operating expenses. Other profitability ratios include:
- Return on Assets: The return on assets ratio (ROA) is found by dividing the net income by total assets. The higher the ratio, the better the company is at using their assets to generate income (i.e., how many dollars of earnings they derive from each dollar of assets they control). It is also a measure of how much the company relies on assets to generate profit. The return on assets gives an indication of the company's capital intensity, which will depend on the industry. Companies that require large initial investments will generally have reduced return on assets.
- Profit Margin: The profit margin is one of the most used profitability ratios. The profit margin refers to the amount of profit that a company earns through sales. The profit margin ratio is broadly the ratio of profit to total sales times one hundred percent. The higher the profit margin, the more profit a company earns on each sale. The profit margin is mostly used for internal comparison. It is difficult to accurately compare the net profit ratio for different entities. A low profit margin indicates a low margin of safety and a higher risk that a decline in sales will erase profits and result in a net loss or a negative margin.
- Return on Equity: The return on equity (ROE) measures profitability related to ownership. It measures a firm's efficiency at generating profits from every unit of the shareholders' equity. ROEs between 15 percent and 20 percent are generally considered good. The ROE is equal to the net income divided by the shareholder equity.
- Basic Earning Power Ratio: The basic earning power ratio (or BEP ratio) compares earnings separately from the influence of taxes or financial leverage to the assets of the company. The BEP is equal to the earnings before interest and taxes divided by the total assets. The BEP differs from the ROA in that it includes the non-operating income.
- Gross Profit Ratio: This indicates what portion of each sales dollar is available to meet expenses and generate profit after taking into account the cost of goods sold. Generally, it is calculated as the selling price of an item minus the cost of goods sold (production or acquisition costs).