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 revenue, operating costs, balance sheet assets, and shareholders' equity over time, using data from a specific point in time.
The Value of Profitability Ratios
- Profitability ratios consist of a group of metrics that assess a company's ability to generate revenue relative to its revenue, operating costs, balance sheet assets, and shareholders' equity.
- Profitability ratios also show how well companies use their existing assets to generate profit and value for shareholders.
- Higher ratio results are often more favorable, but ratios provide much more information when compared to results from other, similar companies, the company's own historical performance, or the industry average.
What Do Profitability Ratios Tell You?
For most profitability 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. Ratios are most informative and useful when used to compare a subject company to other, similar companies, the company's own history, or average ratios for the company's industry as a whole.
For example, gross profit margin is one of the most often-used profitably or margin ratios. Some industries experience seasonality in their operations, such as the retail industry. Retailers typically experience significantly higher revenues and earnings during the year-end holiday season. It would not be useful to compare a retailer's fourth-quarter gross profit margin with its first-quarter gross profit margin because it would not reveal directly comparable information. Comparing a retailer's fourth-quarter profit margin with its fourth-quarter profit margin from the same period a year before would be far more informative.
Examples of Profitability Ratios
Profitability ratios are the most popular metrics used in financial analysis, and they generally fall into two categories: margin ratios and return ratios. Margin ratios give insight, from several different angles, on a company's ability to turn sales into profit.
Return ratios offer several different ways to examine how well a company generates a return for its shareholders. Some examples of profitability ratios are profit margin, return on assets (ROA) and return on equity (ROE).
Margin Ratios: Profit Margin
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 the 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 expenses. The pretax margin shows a company's profitability after further accounting for non-operating expenses. Net profit margin concerns a company's ability to generate earnings after taxes.
Return Ratios: 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, returns may grow at a faster rate than assets, ultimately increasing return on assets.
Return Ratios: Return on Equity
ROE is a ratio that concerns a company's equity holders the most since it measures their ability to earn a 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 a better return with higher margins, equity holders can retain much of the return growth when additional assets are the result of debt use.