# Profitability Ratios

**By:** Shaun **From:** www.myaccountingcourse.com

**Profitability ratios compare income statement accounts and categories to show a company’s ability to generate profits from its operations.** Profitability ratios focus on a company’s return on investment in inventory and other assets. These ratios basically show how well companies can achieve profits from their operations.

Investors and creditors can use profitability ratios to judge a company’s return on investment based on its relative level of resources and assets. In other words, profitability ratios can be used to judge whether companies are making enough operational profit from their assets. In this sense, profitability ratios relate to efficiency ratios because they show how well companies are using thier assets to generate profits. Profitability is also important to the concept of solvency and going concern.

Here are some of the key ratios that investors and creditors consider when judging how profitable a company should be:

# Gross Margin Ratio

### Explanation

Gross margin ratio is a profitability ratio that compares the gross margin of a business to the net sales. This ratio measures how profitable a company sells its inventory or merchandise. In other words, the gross profit ratio is essentially the percentage markup on merchandise from its cost. This is the pure profit from the sale of inventory that can go to paying operating expenses. Gross margin ratio is often confused with the profit margin ratio, but the two ratios are completely different. Gross margin ratio only considers the cost of goods sold in its calculation because it measures the profitability of selling inventory. Profit margin ratio on the other hand considers other expenses.

### Formula

### Analysis

Gross margin ratio is a profitability ratio that measures how profitable a company can sell its inventory. It only makes sense that higher ratios are more favorable. Higher ratios mean the company is selling their inventory at a higher profit percentage. High ratios can typically be achieved by two ways. One way is to buy inventory very cheap. If retailers can get a big purchase discount when they buy their inventory from the manufacturer or wholesaler, their gross margin will be higher because their costs are down. The second way retailers can achieve a high ratio is by marking their goods up higher. This obviously has to be done competitively otherwise goods will be too expensive and customers will shop elsewhere. A company with a high gross margin ratios mean that the company will have more money to pay operating expenses like salaries, utilities, and rent. Since this ratio measures the profits from selling inventory, it also measures the percentage of sales that can be used to help fund other parts of the business. Here is another great explanation.

# Profit Margin Ratio

### Explanation

The profit margin ratio, also called the return on sales ratio or gross profit ratio, is a profitability ratio that measures the amount of net income earned with each dollar of sales generated by comparing the net income and net sales of a company. In other words, the profit margin ratio shows what percentage of sales are left over after all expenses are paid by the business. Creditors and investors use this ratio to measure how effectively a company can convert sales into net income. Investors want to make sure profits are high enough to distribute dividends while creditors want to make sure the company has enough profits to pay back its loans. In other words, outside users want to know that the company is running efficiently. An extremely low profit margin would indicate the expenses are too high and the management needs to budget and cut expenses. The return on sales ratio is often used by internal management to set performance goals for the future.

### Formula

### Analysis

The profit margin ratio directly measures what percentage of sales is made up of net income. In other words, it measures how much profits are produced at a certain level of sales. This ratio also indirectly measures how well a company manages its expenses relative to its net sales. That is why companies strive to achieve higher ratios. They can do this by either generating more revenues why keeping expenses constant or keep revenues constant and lower expenses. Since most of the time generating additional revenues is much more difficult than cutting expenses, managers generally tend to reduce spending budgets to improve their profit ratio. Like most profitability ratios, this ratio is best used to compare like sized companies in the same industry. This ratio is also effective for measuring past performance of a company.

# Return on Assets Ratio

### Explanation

The return on assets ratio, often called the return on total assets, is a profitability ratio that measures the net income produced by total assets during a period by comparing net income to the average total assets. In other words, the return on assets ratio or ROA measures how efficiently a company can manage its assets to produce profits during a period. Since company assets’ sole purpose is to generate revenues and produce profits, this ratio helps both management and investors see how well the company can convert its investments in assets into profits. You can look at ROA as a return on investment for the company since capital assets are often the biggest investment for most companies. In this case, the company invests money into capital assets and the return is measured in profits.

### Formula

### Analysis

The return on assets ratio measures how effectively a company can turn earn a return on its investment in assets. In other words, ROA shows how efficiently a company can covert the money used to purchase assets into net income or profits. Since all assets are either funded by equity or debt, some investors try to disregard the costs of acquiring the assets in the return calculation by adding back interest expense in the formula. It only makes sense that a higher ratio is more favorable to investors because it shows that the company is more effectively managing its assets to produce greater amounts of net income. A positive ROA ratio usually indicates an upward profit trend as well. ROA is most useful for comparing companies in the same industry as different industries use assets differently. For instance, construction companies use large, expensive equipment while software companies use computers and servers.

# Return on Capital Employed

### Explanation

Return on capital employed or ROCE is a profitability ratio that measures how efficiently a company can generate profits from its capital employed by comparing net operating profit to capital employed. In other words, return on capital employed shows investors how many dollars in profits each dollar of capital employed generates. ROCE is a long-term profitability ratio because it shows how effectively assets are performing while taking into consideration long-term financing. This is why ROCE is a more useful ratio than return on equity to evaluate the longevity of a company. This ratio is based on two important calculations: operating profit and capital employed. Net operating profit is often called EBIT or earnings before interest and taxes. EBIT is often reported on the income statement because it shows the company profits generated from operations. EBIT can be calculated by adding interest and taxes back into net income if need be.

### Formula

### Analysis

The return on capital employed ratio shows how much profit each dollar of employed capital generates. Obviously, a higher ratio would be more favorable because it means that more dollars of profits are generated by each dollar of capital employed. For instance, a return of .2 indicates that for every dollar invested in capital employed, the company made 20 cents of profits. Investors are interested in the ratio to see how efficiently a company uses its capital employed as well as its long-term financing strategies. Companies’ returns should always be high than the rate at which they are borrowing to fund the assets. If companies borrow at 10 percent and can only achieve a return of 5 percent, they are loosing money. Just like the return on assets ratio, a company’s amount of assets can either hinder or help them achieve a high return.

# Return on Equity Ratio

### Explanation

The return on equity ratio or ROE is a profitability ratio that measures the ability of a firm to generate profits from its shareholders investments in the company. In other words, the return on equity ratio shows how much profit each dollar of common stockholders’ equity generates. So a return on 1 means that every dollar of common stockholders’ equity generates 1 dollar of net income. This is an important measurement for potential investors because they want to see how efficiently a company will use their money to generate net income. ROE is also and indicator of how effective management is at using equity financing to fund operations and grow the company.

### Formula

### Analysis

Return on equity measures how efficiently a firm can use the money from shareholders to generate profits and grow the company. Unlike other return on investment ratios, ROE is a profitability ratio from the investor’s point of view—not the company. In other words, this ratio calculates how much money is made based on the investors’ investment in the company, not the company’s investment in assets or something else. That being said, investors want to see a high return on equity ratio because this indicates that the company is using its investors’ funds effectively. Higher ratios are almost always better than lower ratios, but have to be compared to other companies’ ratios in the industry. Since every industry has different levels of investors and income, ROE can’t be used to compare companies outside of their industries very effectively.

**“Do you know your numbers? Knowing your numbers starts with knowing and understanding how the numbers are generated”.**