• Profitability ratios attempt to show how well the Company did, given the Level of risk.

 

  • Again, profitability ratios have to be read with other ratios to get a more accurate picture of the Company's performance.

 

  • Net income by itself, cannot be meaningfully compared with that of competitors, or industry averages.

 

  • Levels of investment, share prices may be higher than ours: no two companies can be compared in performance without taking various parameters into account.

 

 

Margin Ratios

Margin ratios are one common class of profitability ratios:

Gross Margin Ratio =
Gross margin x 100%
Sales

 

This is calculated to determine the selling price so that there is adequate gross profit to cover the operating expenses, fixed charges, dividends etc.

 

Operating Margin Ratio =
Operating margin  x 100%
Sales


This is calculated to test the operational efficiency of the business.

 

Net Profit Margin Ratio =
Net profit margin  x 100%
Sales


This is worked out to determine whether operating cost is within desired parameters or not. An increase in this ratio over the previous period shows improvement in the operational efficiency.

 

Margins are closely watched: The potato wafers or supermarket businesses operate on about 2% margins. A small slip can wipe out their profits.

 

Return on Investment Ratios

  • ROI ratios are another broad category of profitability ratios.

 

  • Definitions of ROI vary from company to company.

 

  • Understand pros and cons of whatever ROI ratio your company uses.

 

  • Basically, Return on Assets (ROA) is an ROI measure that evaluates returns generated by an asset base.

 

  • Dividing profits earned, by assets used to generate these profits = ROI (return on Investment).

 

  • Good for evaluating performance of Sub-Divisions/Profit Centres.

 

  • Shareholders are interested in return on equity i.e. ROE.

 

Return On Assets (ROA) =
Profit before Interest & Tax
Total Assets

 

Return On Equity (ROE) =
Net Profit
Shareholders' equity

 This ratio is used to compare the performance of a company's equity capital with that of other companies, which are alike in quality. The company with higher ROE will be favoured by the investors.