What are Profitability Ratios?

A profitability ratio is like an event at the World’s Strongest Man competition…

To claim the World’s Strongest Man title, competitors need to go through a series of challenging events, including lifting heavy stones, tossing kegs, and carrying fridges. A single event doesn’t determine who’s strongest, and competitors need to gain the most points from all activities. Likewise, a profitability ratio assesses a company’s profitability using a specific metric, but an investor would need to use several profitability ratios to get a full picture of its financial health.

Profitability ratios give you a sense of a company’s ability to generate a profit. Profitability ratios are also accounting ratios because they use information from a company’s balance sheet (a snapshot of the company’s assets, liabilities, and shareholder equity) and income statement (a breakdown of revenue and expenses).

There are two types of profitability ratios, categorized based on what they measure: return on revenue (e.g., Operating Profit Margin = Operating Income / Revenue) or return on investment (e.g., return on equity (ROE) = Net Income / Average Total Equity).

Four common uses of profitability ratios are: analyzing a company’s profitability, estimating its value, assessing its overall financial health, and evaluating management performance.

Company owners, financial analysts, investors, and other corporate stakeholders are interested in determining a company's profitability. You can use profitability ratios to evaluate a company’s ability to profit from operations and generate a return on investment. A profit motive is the guiding principle of running a business and is key to maintaining sustainable business operations in the long run.

Company owners, investors, and financial analysts use profitability ratios to make an appraisal — an estimated valuation of the company.

Company stakeholders analyze a company’s profitability ratios:

• Over a period of time
• Against profitability ratios of comparable companies
• Against the rest of the industry

These three comparisons allow you to find trends and, combined with other data, can help make forecasts about the company’s future profitability. Using all of this information and other accounting ratios (e.g., solvency ratios, activity ratios, and valuation ratios) you can estimate the value of the company as a whole. If it’s a publicly traded company, the stock price should reflect that estimated value.

Another use of profitability ratios is to evaluate a management team’s performance in using assets to create a profit and gain a competitive advantage in the market.

Profitability ratios provide objective measures for setting corporate goals and evaluating management performance against those goals. For example, a company can refer to the return on invested capital — a profitability ratio assessing the use of invested capital to create a profit — in earnings calls when discussing management performance.

Creditors and lenders use profitability ratios in addition to liquidity ratios (which measure a company’s ability to pay debt due within a year) and solvency ratios (which measure a company’s ability to pay long-term debt) to evaluate the overall financial health of a company.

A company can maintain sustainable operations by continuously creating more revenue than it spends. By maintaining a profit, a company may have additional cash to meet its short-term and long-term financial obligations.

The two categories of profitability ratios are those that focus on:

• Return on revenue: Profitability ratios that use key items from the income statement (such as earnings before taxes (EBT) and the net income) and calculate them as percentages of revenue. These profitability ratios are also referred to as margin ratios or return-on-sales ratios.
• Example: Gross Profit Margin = Gross Profit / Revenue
• Return on investment: Profitability ratios that evaluate income as a percentage of assets, equity, or capital invested.
• Example: Return on Equity (ROE) = Net Income / Average Total Equity

To review common profitability ratios, let's first take a look at some return-on-sales profitability ratios and their formulas.

A common feature of return-on-sales profitability ratios is that they express a type of income as a percentage of revenue.

Gross Profit Margin

Gross Profit Margin = Gross Profit / Revenue

Gross profit is revenue minus the cost of goods sold (COGS) — the total direct expense of creating a good or service — from a company’s revenue.

The gross profit margin calculates gross profit as a percentage of revenue.

Operating Profit Margin

Operating Profit Margin = Operating Income / Revenue

Operating income is revenue minus income that’s not directly related to operations (such as investments), cost of goods sold (COGS), and operating expenses (expenses directly related to a company’s day-to-day operations).

The operating profit margin calculates the percentage of revenue that covers a company’s operating expenses and results in a profit.

Pretax Margin

Pretax Margin = Earnings Before Taxes (EBT) / Revenue

EBT is pretax profit minus interest.

The pretax margin calculates the amount of profit generated before taxes as a percentage of revenue.

Net Profit Margin

Net Profit Margin = Net Income / Revenue

Net income is revenue minus all expenses. It’s also known as a company’s bottom line. Typically, you adjust the net income from a company’s income statement by removing non-recurring expenses (aka one-time expenses) to get a more accurate view of the company’s ongoing profitability.

The net profit margin expresses net income as a percentage of revenue.

Now let’s review commonly used return-on-investment profitability ratios and their formulas. These ratios indicate different types of income as a percentage of assets, liabilities, or shareholder’s equity.

Return on Assets (ROA)

ROA = Net Income / Average Total Assets

ROA calculates profit as a percentage of total assets. When using balance sheet items at the end of a period (such as a quarter or year), you can use the listed value for total assets. However, when calculating ROA during the period, you should take an average of the assets over the period.

Operating Return on Assets

Operating Return on Assets = Operating Income / Average Total Assets

Operating return on assets is different from ROA because it uses income before deducting interest payments. The main reason to use operating income is to account for all assets, both owned by the company and those financed with debt.

Return on Total Capital

Return on Total Capital = Operating Income / (Short-term Debt + Long-term Debt + Equity)

Sources of capital for a company can come from selling shares or taking out loans or other types of debt. The return on total capital expresses operating income as a percentage of all sources of company capital.

Return on Equity (ROE)

ROE = Net Income / Average Total Equity

ROE expresses net income as a percentage of all types of equity, including common and preferred shares. Unlike the return on total capital, ROE focuses only on capital that comes from equity sources.

You can analyze profitability by applying profitability ratios over several periods (such as quarters or years) and reviewing how they change over time.

For example, you could review the return-on-sales profitability ratios of a company for the past five years.

Alternatively, you could compare the profitability ratios of one company against those of a comparable company or an industry average. For instance, you could compare the profitability ratios of a car manufacturer with those of a similar car company over the past three quarters.

Another option would be to compare the car manufacturers’s profitability ratios with the average profitability ratios of the entire auto industry.

When analyzing the profitability of a company over a period or against comparables, you should be consistent in how you calculate the profitability ratios. Consistency is essential so that you can genuinely make an apples-to-apples comparison of the profitability ratios.

The guiding principle for interpreting profitability ratios is that the higher the profitability ratio, the higher the company’s profitability.

For example, a consistent increase in return on assets (ROA) from one quarter to the next indicates that a company is getting better at generating profits from its assets. Alternatively, a consistent decrease in ROA would signal that the company has gotten worse at making profits from its assets over the same period.

Another useful guideline is to review the comments and footnotes provided by management in financial statements (such as the balance sheet or income statement) and other reports (such as the annual report for publicly traded companies). Management commentary can offer useful context to make necessary modifications in the calculation of profitability ratios. For example, a note to the income statement could help you to identify non-recurring expenses that could affect net income.

Another guideline for interpreting profitability ratios is to complement profitability ratios with other financial ratios, such as activity, liquidity, and solvency ratios. The use of all financial ratios is referred to as an integrated financial ratio analysis. Using a different type of financial ratio may answer a question raised by one type of financial ratio.