What Is Profitability Ratio Analysis?

Every firm is most concerned with its profitability. One of the most frequently used tools of financial ratio analysis is profitability ratios. They are used to determine the company's bottom line for its managers and its return on equity to its investors. Profitability measures are important to company managers and owners alike. Management has to have a measure of profitability in order to steer the business in the right direction. If a business has outside investors who have purchased stock in the company, the company management has to show profitability to those equity investors.

Profitability ratios, as discussed and illustrated below, show a company's overall efficiency in using its assets and performance at the end of each quarter or year. Profitability ratios are divided into two types: margin ratios and return ratios. 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.

Comparative Ratio Analysis

Managers generally use either trend or industry analysis. Trend analysis involves, in this case, looking at the business's profitability ratios over time and looking for positive and negative trends. Industry analysis is the comparison of a business's profitability ratios to those of other businesses in the same industry sector.

Margin Ratios

Gross Profit Margin

The gross profit margin calculates the cost of goods sold as a percent of sales—both numbers can be found on the income statement. This ratio looks at how well a company controls the cost of its inventory and the manufacturing of its products and subsequently passes on the costs to its customers. The larger the gross profit margin, the better for the company.

Calculate gross profit margin by first subtracting the cost of goods sold from sales. If sales are $100 and the cost of goods sold is $60, the gross profit is $40. Then divide gross profit by sales which would be: $40 / $100 = 40%. The gross profit margin, which is the amount of sales revenue that can be devoted to utilities, inventory, and manufacturing costs is 40% of sales.

Operating Profit Margin

The operating profit is usually called earnings before interest and taxes or EBIT on a business's income statement. The operating profit margin is EBIT as a percentage of sales. It is a measure of a company's overall operating efficiency. It differs from the gross profit margin by further subtracting out the expenses of ordinary, daily business activity from sales.

The operating profit margin is calculated using this formula: EBIT / Sales. If EBIT is $20 and sales are $100, then the operating profit margin is 20%. Both terms of the equation come from the company's income statement.

Net Profit Margin

When doing a simple profitability ratio analysis, the net profit margin is the most often margin ratio used. The net profit margin shows how much of each sales dollar remains 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 of sales made are profit. The net profit margin measures profitability after consideration of all expenses including taxes, interest, and depreciation. The calculation is: Net Income / Net Sales =_%. Both terms of the equation come from the income statement.

Cash Flow Margin

The cash flow margin ratio is an important ratio as it expresses the relationship between cash generated from operations and sales. The company needs cash to pay dividends, suppliers, service debt, and invest in new capital assets, so cash is just as important as profit to a business firm. The Cash Flow Margin ratio measures the ability of a firm to translate sales into cash. The calculation is Cash From Operating Cash Flows / Net Sales = _%. The numerator of the equation comes from the firm's Statement of Cash Flows. The denominator comes from the Income Statement.

Return Ratios

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. The return on assets ratio is related to the asset management category of financial ratios.

The calculation for the return on assets ratio is: Net Income / Total Assets = _%. Net income is taken from the income statement, and total assets are taken from the balance sheet. The higher the percentage, the better, because that means the company is doing a good job using its assets to generate sales.

Return on Equity

The return on equity ratio is perhaps the most important of all the financial ratios to a publicly-held company's investors. It measures the return on the money the investors have put into the company. It is the ratio potential investors look at when deciding whether or not to invest in the company. The calculation is Net Income / Stockholders Equity = _%. Net income comes from the income statement, and stockholder's equity comes from the balance sheet. In general, the higher the percentage, the better, with some exceptions, as it shows that the company is doing a good job using the investors' money.

Cash Return on Assets

The cash return on assets ratio is generally used only in more advanced profitability ratio analysis. It is used as a cash comparison to return on assets since the return on assets is stated on an accrual basis. Cash is required for future investments. The calculation is Cash Flow From Operating Activities / Total Assets = _%. The numerator is taken from the Statement of Cash Flows and the denominator from the balance sheet. The higher the percentage, the better.

Tying It All Together: The DuPont Model

There are many financial ratios—liquidity ratios, debt or financial leverage ratios, efficiency or asset management ratios, and profitability ratios—that it is often hard to see the big picture. You can get bogged down in the detail.

The DuPont Model can show a business owner where the component parts of the return of assets (or return on investment ratio) come from as well as the return on equity ratio. For example, did return on assets come from net profit or asset turnover? Did return on equity come from net profit, asset turnover, or the business's debt position? The DuPont model is very helpful to business owners in determining if and where financial adjustments need to be made.