What are the profitability ratios?
Profitability ratios are a class of financial metrics that are used to assess the ability of a business to generate profits in relation to its revenues, operating costs, balance sheet assets and equity over time, using data from a specific time.
The value of profitability ratios
Key points to remember
- Profitability ratios consist of a group of parameters that assess a company’s ability to generate income in relation to its income, operating costs, balance sheet assets and equity.
- Profitability ratios also show the extent to which companies use their existing assets to generate profit and shareholder value.
- Higher ratios are often more favorable, but the ratios provide much more information relative to the results of other similar companies, the company’s historical performance or the industry average.
What do the profitability ratios tell you?
For most profitability ratios, having a higher value compared to a competitor’s ratio or compared to the same ratio from a previous period indicates that the business is doing well. The ratios are more informative and useful when used to compare a given company to other similar companies, to its own history, or to average ratios for the industry as a whole.
For example, gross profit margin is one of the most used profitability or margin ratios. Some industries experience seasonal variations in their operations, such as retail trade. Retailers typically have significantly higher revenues and revenues during the holiday season. It would not be useful to compare a retailer’s gross profit margin in the fourth quarter with its gross profit margin in the first quarter, as it would not reveal directly comparable information. Comparing a retailer’s profit margin in the fourth quarter with its profit margin in the fourth quarter of the same period a year ago would be much more instructive.
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 yield ratios. Margin ratios provide insight, from several different angles, of a company’s ability to turn sales into profits.
Yield ratios offer several different ways of looking at how well a business is generating returns 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 the profitability of a business at different cost levels, including gross margin, operating margin, pre-tax margin and net profit margin. Margins are reduced as additional cost levels are taken into account, such as cost of goods sold (COGS), operating and non-operating expenses and taxes paid.
Gross margin measures how well a business can increase sales above COGS. The operating margin is the percentage of sales remaining after covering additional operating expenses. The pre-tax margin shows the profitability of a business after taking into account non-operating expenses. The net profit margin concerns the ability of a business to generate profit after tax.
Yield ratios: return on assets
Profitability is measured against costs and expenses, and it is analyzed against assets to see the effectiveness of a business in deploying assets to generate sales and possibly profits. The term yield in the ROA ratio generally refers to net profit or net income, the amount of sales revenue after all costs, expenses and taxes.
The more assets a company has accumulated, the more it can generate sales and potentially more profits. With economies of scale helping to reduce costs and improve margins, returns can grow at a faster rate than assets, ultimately increasing the return on assets.
Yield ratios: return on equity
ROE is a ratio that most concerns the shareholders of a company because it measures their ability to generate a return on their equity investments. ROE can increase significantly without adding equity when it can simply benefit from a higher return, helped by a larger asset base.
When a business increases the size of its assets and generates a better return with higher margins, shareholders can retain much of the growth in return when additional assets are the result of the use of debt.