How well is the business performing over a specific period, will the firm have the financial resources to continue serving its constituents tomorrow as well as today? Profitability ratios offer several different measures of the success of the firm at generating profits.
Every firm is most concerned with its profitability. One of the most frequently used tools of financial ratio analysis is profitability ratios which are used to determine the company’s bottom line and its return to its investors. Profitability measures are important to company managers and owners alike. If a small business has outside investors who have put their own money into the company, the primary owner certainly has to show profitability to those equity investors.
Profitability ratios show a company’s overall efficiency and performance. Ratios that show margins represent the firm’s ability to translate sales dollars into profits at various stages of measurement. Ratios that show returns represent the firm’s ability to measure the overall efficiency of the firm in generating returns for its shareholders.
Gross profit margin
How much profit is earned on your products without considering indirect costs? Is your gross profit margin improving? Small changes in gross margin can significantly affect profitability. Is there enough gross profit to cover your indirect costs? Is there a positive gross margin on all products?
The gross profit margin is a measure of the gross profit earned on sales. It considers the firm’s cost of goods sold, but does not include other costs. The gross profit margin looks at cost of goods sold as a percentage of sales. This ratio looks at how well a company controls the cost of its inventory and the manufacturing of its products and subsequently pass on the costs to its customers. The larger the gross profit margin, the better for the company.
It is defined as follows:
Net Profit Margin
When doing a simple profitability ratio analysis, net profit margin is the most often margin ratio used. How much money are you making per every $ of sales. The net profit margin shows how much of each sales dollar shows up as net income after all expenses are paid. For example, if the net profit margin is 5%, that means that 5 cents of every dollar is profit.
This ratio measures your ability to cover all operating costs including indirect costs. The net profit margin measures profitability after consideration of all expenses including taxes, interest, and depreciation.
The net profit margin is a number which indicates the efficiency of a company at its cost control. A higher net profit margin shows more efficiency of the company at converting its revenue into actual profit. This ratio is a good way of making comparisons between companies in the same industry, for such companies are often subject to similar business conditions.
It is defined as follows:
Return on assets
The Return on Assets ratio is an important profitability ratio because it measures the efficiency with which the company is managing its investment in assets and using them to generate profit. It measures the amount of profit earned relative to the firm’s level of investment in total assets
This is a very useful measure of comparison within an industry.
A low ratio compared to industry may mean that your competitors have found a way to operate more efficiently.
It is defined as:
Total Average Assets = (Beginning Total Assets + Ending Total Assets) / 2
Return on equity
Return on equity is the amount of net income returned as a percentage of shareholders equity. Moreover, the return on equity estimates the profitability of a corporation by revealing the amount of profit generated by a company with the money invested by the shareholders. Return on equity is the bottom line measure for the shareholders, measuring the profits earned for each dollar invested in the firm’s stock. It is the rate of return on investment by shareholders.
This is one of the most important ratios to investors. Are you making enough profit to compensate for the risk of being in business? How does this return compare to less risky investments like bonds? This is the ratio potential investors look at when deciding whether or not to invest in the company.
Return on equity is defined as follows:
