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, or shareholders' equity over time, using data from a specific point in time.
- Profitability ratios are metrics that assess a company's ability to generate income relative to its revenue, operating costs, balance sheet assets, or shareholders' equity.
- Profitability ratios show how efficiently a company generates profit and value for shareholders.
- Higher ratio results are often more favorable, but ratios provide much more information when compared to results of similar companies, the company's own historical performance, or the industry average.
The Value of Profitability Ratios
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. Profitability ratios are most useful when compared to similar companies, the company's own history, or average ratios for the company's industry.
For example, gross profit margin is one of the most-used profitability or margin ratios. Gross profit is the difference between revenue and the costs of production—called cost of goods sold (COGS). 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.
Thus, it would not be useful to compare a retailer's fourth-quarter gross profit margin with its first-quarter gross profit margin because they are not directly comparable. Comparing a retailer's fourth-quarter profit margin with its fourth-quarter profit margin from the previous year would be far more informative.
Example of How to Use Profitability Ratios
Profitability ratios are one of 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 a 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 the profit margin, return on assets (ROA), and return on equity (ROE).
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 expenses, and taxes.
Gross margin measures how much a company makes after accounting for COGS. Operating margin is the percentage of sales left after covering COGS and operating expenses. The pretax margin shows a company's profitability after further accounting for non-operating expenses. The net profit margin is a company's ability to generate earnings after all expenses and taxes.
Return on Assets
Profitability is assessed relative to costs and expenses and analyzed in comparison to assets to see how effective a company is deploying assets to generate sales and profits. The use of the term "return" in the ROA ratio customarily refers to net profit or net income—the value of earnings from sales after all costs, expenses, and taxes. ROA is net income divided by total assets.
The more assets a company has amassed, the more sales and potential 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 ROA.
Return on Equity
ROE is a key ratio for shareholders, as it measures a company's ability to earn a return on its equity investments. ROE is net income divided by shareholders' equity. ROE may increase without additional equity investments, as the ratio can rise due to higher net income due to a larger asset base funded with debt.