Efficiency ratios and profitability ratios are tools used in fundamental analysis. These ratios help investors with their investment decisions, and each indicates something different about a business. Profitability ratios depict how much profits a company is generating, whereas efficiency ratios measure how efficient a company utilizes its resources to generate a profit.
Profitability ratios measure a company's ability to generate profits within a specified context. Profitability ratios measure the overall performance of a company through profits. Profitability ratios are used to compare a company's ability to generate profits relative to its industry, or the same ratios can be compared within the same company for different periods. One ratio used to measure a company's profitability is return on equity (ROE), which measures the amount a company generates with the funds raised from shareholders' equity. It is calculated by dividing net income by shareholders' equity.
For example, an investor can compare the return on investment (ROI) of a company with the average ROE of its industry. He can also compare the ROE for the current fiscal period to a past fiscal period to evaluate how well a company is doing.
On the other hand, efficiency ratios are used to measure how well a company is using its assets and liabilities to generate income. Efficiency ratios are more specific than profitability ratios, using specific measurements of a company to gauge its efficiency. Ratios that are used to measure a company's efficiency include the asset turnover ratio, which measures the amount of revenue a company generates per dollar of assets. It is calculated by dividing a company's sales by its total assets. This reveals how well a company is using its assets to generate sales.