What are Profitability Ratios?
Profitability ratios are financial metrics used by businesses to measure and evaluate their ability to generate income relative to sales, assets, costs, and equity during a specific period of time. They show how well a company utilizes its assets to produce profit and value to shareholders. A higher ratio or value is sought-after by most companies, as this would mean the business is doing well at generating profits, revenues and cash flows. The ratios can only be useful when they are analyzed in comparison to competitors or compared to previous periods.
What are the Different Types of Profitability Ratios?
There are various profitability ratios that are used by companies to provide useful insights into the financial well-being and performance of the business. All of these ratios can be generalized into two categories which are the following:
- Margin ratios – these represent the company’s ability to convert sales into profits at various degrees of measurement. Examples are: gross profit margin, operating profit margin, net profit margin, net interest margin, cash flow margin, EBIT, EBITDA, EBITDARM, NOPLAT, operating expense ratio, and overhead ratio.
- Return ratios – these represent the company’s ability to measure the overall productivity of the business’s ability to generate returns to its shareholders. Examples are: return on assets, return on equity, cash return on assets, return on debt, return on retained earnings, return on revenue, risk-adjusted return, return on invested capital, and return on capital employed.
What are the Most Commonly Used Profitability Ratios and Their Significance?
Most companies refer to profitability ratios when analyzing business productivity through comparing income to sales, assets, and equity. Some of the frequently used ratios are:
- Gross profit margin – compares gross profit to sales revenue. This shows how much a business is earning, taking into account the needed costs to produce its goods and services. A high gross profit ratio represents a higher efficiency of core operations, meaning it can still cover operating expenses, fixed costs, dividends, and depreciation, while also providing net earnings to the business. On the other hand, low profit margin encompasses a high cost of goods sold, which can be attributed to adverse purchasing policies, low selling prices, low sales, stiff market competition, or wrong sales promotion policies.
- Operating profit margin – looks at earnings as a percentage of sales before income tax is taken away. Companies with high operating profit margins are generally more equipped to pay for fixed costs and interest on obligations, have better chances to survive an economic slowdown, and are more capable of offering lower prices than their competitors who have a low profit margin.
- Cash flow margin – expresses the relationship between cash flows from operating activities and sales generated by the business. It measures the ability of the company to convert sales into cash. The higher the percentage of cash flow means the more cash available from sales to pay for suppliers, dividends, utilities, and debt as well as purchase capital assets. A negative cash flow however, connotes that even if the business is generating sales, it is still losing money. In this case, the company has an option to borrow funds or raise money through investors in order to keep the operations going.
- Return on assets (ROA) – shows the percentage of net earnings relative to the company’s total assets, in other words how much a company generates for every one dollar of assets, after-tax profit. This also measures the asset intensity of a business, meaning the lower the profit per dollar of assets, the more asset-intensive a company is In contrast, the higher the profit per dollar of assets, the less asset-intensive a company is. Highly asset-intensive companies require big investments to purchase machinery and equipment in order to generate income. Examples are: telecommunications services, car manufacturers, and railroads. Less asset-intensive companies are: advertising agencies and software companies.
- Return on equity (ROE) – expresses the percentage of net income to stockholder’s equity or the rate of return on the money the investors put into the business. This is also the ratio that potential investors are referring to when deciding whether to invest or not. A high return on equity is more capable of generating cash internally. Usually return rates ranging from 13% to 15% illustrate a healthy ROE.