Loading the player...

What are 'Profitability Ratios'

Profitability ratios are a class of financial metrics that are used to assess a business's ability to generate earnings relative to its associated expenses. For most of these ratios, having a higher value relative to a competitor's ratio or relative to the same ratio from a previous period indicates that the company is doing well.

BREAKING DOWN 'Profitability Ratios'

Some industries experience seasonality in their operations. The retail industry, for example, typically experiences higher revenues and earnings for the Christmas season. It would not be useful to compare a retailer's fourth-quarter profit margin with its first-quarter profit margin. Comparing a retailer's fourth-quarter profit margin with the profit margin from the same period a year before would be far more informative.

Some examples of profitability ratios are profit margin, return on assets (ROA) and return on equity (ROE). Profitability ratios are the most popular metrics used in financial analysis. Read the short guide on Profitability Indicator Ratios: Introduction.

Profit Margins

Different profit margins are used to measure a company's profitability at various cost levels, including gross margin, operating margin, pretax margin and net profit margin. The margins shrink as layers of additional costs are taken into consideration, such as cost of goods sold (COGS), operating and nonoperating expenses, and taxes paid. Gross margin measures how much a company can mark up sales above COGS. Operating margin is the percentage of sales left after covering additional operating expense. The pretax margin shows a company's profitability after further accounting for nonoperating expense. Net profit margin concerns a company's ability to generate earnings after taxes.

Return on Assets

Profitability is assessed relative to costs and expenses, and it is analyzed in comparison to assets to see how effective a company is in deploying assets to generate sales and eventually profits. The term return in the ROA ratio customarily refers to net profit or net income, the amount of earnings from sales after all costs, expenses and taxes. The more assets a company has amassed, the more sales and potentially more profits the company may generate. As economies of scale help lower costs and improve margins, return may grow at a faster rate than assets, ultimately increasing return on assets.

Return on Equity

ROE is a ratio that concerns a company's equity holders the most, since it measures their ability of earning return on their equity investments. ROE may increase dramatically without any equity addition when it can simply benefit from a higher return helped by a larger asset base. As a company increases its asset size and generates better return with higher margins, equity holders can retain much of the return growth when additional assets are the result of debt use.

RELATED TERMS
  1. Profit Margin

    Profit margin is a profitability ratios calculated as net income ...
  2. Marginal Profit

    Marginal profit is the profit earned by a firm or individual ...
  3. Accounting Ratio

    Accounting ratios, also known as financial ratios, are used to ...
  4. Operating Margin

    Operating margin is a measure of a company's profitability, and ...
  5. Pretax Profit Margin

    The pretax profit margin is the ratio of a company's pre-tax ...
  6. Operating Ratio

    The operating ratio shows the efficiency of a company's management ...
Related Articles
  1. Investing

    A Look At Corporate Profit Margins

    Take a deeper look at a company's profitability with the help of profit margin ratios.
  2. Investing

    The Difference Between Gross and Net Profit Margin

    To calculate gross profit margin, subtract the cost of goods sold from a company’s revenue; then divide by revenue.
  3. Managing Wealth

    What’s a Good Profit Margin for a New Business?

    Surprisingly, the younger your company is, the better its numbers may look.
  4. Investing

    4 Tips to Evaluate Growth Companies (KO, AAPL)

    Discover the best metrics for stock investors to utilize when selecting and evaluating the best opportunities in growth investing.
  5. Investing

    Analyze Investments Quickly With Ratios

    Make informed decisions about your investments with these easy equations.
  6. Investing

    Profitability Indicator Ratios

    Learn about profit margin analysis, effective tax rate, return on assets, return on equity and return on capital employed.
  7. Investing

    Gross, Operating and Net Profit Margins

    A company’s income statement includes the company’s gross, operating and net profits.
  8. Investing

    Analyzing AT&T's Price & Profitability Ratios in 2016 (T)

    Conduct fundamental analysis on AT&T by examining its price and profitability ratios.
RELATED FAQS
  1. How do gross margin and profit margin differ?

    Gross margin and profit margin are profitability ratios used in evaluating a company's financial health, but they have distinct ... Read Answer >>
  2. Profit margin versus operating margin: What's the difference?

    There are some distinctions between profit margin and operating margin. Both measure efficiency of a firm, but one takes ... Read Answer >>
  3. What is the difference between operating margin and contribution margin?

    Understand the difference between two measures of profitability, operating margin and contribution margin, and the purpose ... Read Answer >>
  4. What is the difference between efficiency ratios and profitability ratios?

    Learn about efficiency and profitability ratios, what these ratios measure and the main difference between efficiency and ... Read Answer >>
  5. What is the difference between EBITDA margin and profit margin?

    Learn about the EBITDA margin and what sets it apart from GAAP-approved profit margins such as the gross margin, operating ... Read Answer >>
  6. How do gross profit and gross margin differ?

    Both gross profit and gross margin measure how profitable a company is during a given period, but each shows profitability ... Read Answer >>
Trading Center