- Last Updated: Thursday, 22 June 2017 21:49

The primary goal of most companies is to make profits for their owners, which in its simplest form can be described as income minus expenses. Profitability ratios help analysts, and investors, to understand just how efficiently a company generates these profits.

In this article, we're going to review seven key profitability ratios. That review will start with a discussion of the usefulness of financial measures. Next, we'll include a definition of each metric, its calculation, as well as how to interpret the results. Then we'll finish up with the pros and cons of these ratios

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Companies need to generate profits; not just to satisfy investors, but also to remain a viable business. If expenses exceed income over a long period of time, the company will likely cease operations. That's why management is always seeking new ways to increase profitability. Both profits, as well as their ratios, can be determined using the company's income statement.

Financial ratios allow the analyst to standardize, or normalize, the data in such a way that comparisons can be made or conclusions can be drawn about relative performance. For example, two companies competing in the same industry might both generate $1 million in profits. Company A required $10 million in revenues, while Company B only needed $2 million to generate this value. Putting the revenue information together with profits allows the analyst to draw some conclusions about the efficiency of Company B relative to Company A.

In the sections below, a number of ratios will be examined, including the gross operating and profit margin. We'll also take a look at several measures that use the balance sheet too.

Also known as the gross profit rate, this first ratio provides insights into how efficiently a company manufactures a product or supplies a service. This measure only requires two inputs: revenues and the cost of goods sold. The closer the gross profit margin is to 100%, the more efficient the operation.

Gross Profit Margin (%) = (Gross Profits / Revenues) x 100

Where:

- Gross Profits = Revenues - Cost of Goods Sold

The cost of goods sold, also known as COGS, includes the expense required to manufacture a product or provide a service. This measure would include expenses such as raw materials, labor, and production overheads. As the gross profit margin approaches 100%, the cost of goods sold approaches zero. Therefore, when comparing two companies in similar industries, the company with the higher margin would be considered more efficient.

One step up from gross profit margin is the measure known as operating margin. Not only does this ratio include the cost of goods sold, it also contains overheads such as selling, general and administrative expense as well as depreciation. It's the income associated with the ongoing operations of the company's core business.

Operating Margin (%) = (Operating Income / Revenues) x 100

Where:

- Operating Income = Gross Profits - Operating Expenses

As was the case with the measures already discussed, higher operating margin ratios indicate more efficiently run companies within a given industry. Since this ratio includes more costs than gross profit margin, it's often cited as a better indicator of profitability. Operating margin does not include non-operating income, interest expense, and income taxes.

When comparing two companies in similar industries, the company with the higher operating margin will be more efficient at manufacturing the product or providing their service.

Also known as net profit margin and net margin, this next ratio takes a very simple approach to evaluating profitability. In addition to the cost of goods sold, selling general and administrative expense and depreciation; this metric also includes non-operating income, interest expense, and income taxes.

Profit Margin (%) = (Net Income / Revenues) x 100

Where:

- Net Income = Revenues - Operating Expenses + Non-Operating Income - Interest Expense - Income Taxes

The advantage of a financial ratio like profit margin is its all-encompassing reach. It tells the investor / analyst how much profit is generated divided by the total revenues of the business. It derives its power from its simplicity.

This same strength is also the shortfall of this ratio. It includes both expenses and income sources that are not part of the company's core business. As such, it's relegated to a second tier measure. It's an interesting metric to monitor, but really doesn't align with a company's ability to efficiently turn revenues into profits.

While the first three ratios examined the relationship of revenues and income, there are additional measures that rely both on the income statement as well as the balance sheet. Some of the more familiar metrics include return on assets and return on equity. The less familiar, but perhaps more powerful, ratios include the DuPont equation and return on invested capital.

The assets required to produce revenues will vary by industry. Therefore, benchmarks and comparisons should only be made between companies that produce similar products or provide essentially the same services.

Since income is derived from assets in use through the year, including new plant or machinery, the value used in the calculation is an average. Return on assets, or ROA, tests management's ability to earn a fair return on assets. The calculation of this ratio is as follows:

Return on Assets (%) = (Net Income / Total Assets) x 100

Where:

- Total Assets = the average total assets of the company, typically found by adding two yearend values for total assets and dividing by two.

The balance sheet tells us that assets are equal to liabilities plus owner's equity. Eliminating the liabilities portion of this equation allows the analyst to see how much profit is generated by the shareholders' investment. The calculation of ROE is as follows:

Return on Equity (%) = (Net Income / Stockholder's Equity) x 100

Where:

- Stockholder's Equity = the average shareholders' equity throughout the year, typically found by adding two yearend values and dividing by two.

Also known as the DuPont model, the DuPont Equation is a complex, but powerful ratio. The measure begins by looking at the company's return on assets (ROA) or return on investment (ROI):

Return on Assets (ROA) = Profit Margin x Total Asset Turnover

This equation can be expanded several times until it takes its final form:

ROA = ((Sales - Total Costs) / Sales) x (Sales / (Current Assets + Non-Current Assets))

The power of this measure is its ability to identify the strengths and weaknesses of a company. The first part of this equation tells the analyst how efficiently a company uses its assets to produce profits. Current assets include cash, accounts receivable, inventories, and marketable securities, while non-current assets include items such as buildings, land, and machinery / equipment.

The second part of this equation tells the analyst how working capital and long-term, income-producing assets are used to help maintain the company's operation.

Return on equity tells the investor the amount of net income generated for the shareholders' equity in the company. Unfortunately, ROE doesn't tell the investor how much debt (leverage) the company is using to generate those profits.

The calculation of ROIC is more complex than ROE and ROA. The equation for this measure appears below:

ROIC = Net Operating Profit after Taxes / Invested Capital

Where:

- Net Operating Profit after Taxes (NOPAT) = Operating Profit x (1 - Tax Rate)
- Invested Capital (IC) = Fixed Assets + Non-Cash Working Capital
- Non-Cash Working Capital = Current Assets - Current Liabilities - Cash

NOPAT allows the investor to calculate a profit figure that takes into consideration the company's capital structure. The denominator of the ROIC equation contains invested capital. This includes fixed assets such as plant, property and equipment. Non-cash working capital contains assets such as accounts receivable and inventory.

ROIC eliminates much of the noise that limits some of the other return calculations. The measure focuses on the income-generating assets of the company.

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