It measure company’s ability to generate income relative to its revenue, operating costs and other cost associated with the generation of income during a particular period.
Types of Profitability Ratios
Conmanly used Profitability Ratios are
- Return on Equity (ROE)
- Return on Assets (ROA)
- Gross Profit Margin
- Operating Profit Margin
Pretax Margin is the earnings before taxes divided by revenue. Net Profit Margin or simply Net Margin is the net income divided by revenues.
To get a better sense of whether these ratios are too high or low, these should be compared to those of its competitors.
Return on Equity (ROE)
ROE is defined as the net income divided by shareholders equity. It measures company profitability by revealing how much profit a company generates with the money shareholders have invested.
Return on Equity = Net income / Shareholder’s equity
Return on Assets (ROA)
ROA is defined as the company’s net income divided by its average total assets. It measure how well a company is performing by comparing net income it’s generating to the capital it’s invested in assets.
Return on Assets = Annual Net Income / Average Total Assets
Net income is the bottom-line figure on Income statement. Average total assets balance is calculated by dividing the sum of total assets at the beginning and at the end of the period by 2. Total assets can be obtained from balance sheet.
Gross Profit Margin
It is defined as the ratio of the company’s gross profit for the year divided by its revenues for the year. Gross profit is the difference between revenues and COGS (Cost of Goods Sold). It shows how much profit a company makes after paying off its COGS. A company would like the gross margin to be high.
Gross Profit Margin = (Revenue – COGS) / Revenue
Revenue and COGS can be obtained from Income Statement.
If the ratio is calculated to be 10%, that means for every rupee of revenue generated, 10 paisa is retained while 90 paisa is attributed to the cost of goods sold. This amount used to pay off general expenses, debts, rent etc.
Operating Profit Margin
It is defined as the operating profit divided by revenue. It reflects the percentage of profit a company produces from its operations, prior to subtracting taxes and interest charges.
Operating Margin = Operating Income / Revenue Operating Income = Revenue - COGS - Operating Expenses - Depreciation & Amortization
Operating income is same as earnings before interest and tax (EBIT). Both operating income and revenue figures can be obtained from the income statement of a company.