Profitability ratios are financial tools that assess the business’s ability to generate profits with its sales, assets, equity, and cash flow. These ratios can be categorized into margin ratios and return ratios. The margin ratios include the gross profit rate, operating profit margin, net profit margin, and operating cash flow margin. On the other hand, return ratios are the return on assets, return on equity, return on capital employed, and dividend yield, etc.
The different profitability ratios evaluate the company’s capacity to generate a profit using varied company data and depending on the assessment’s purpose. These ratios also serve as one of the financial tools utilized by the investors in selecting which investment to embark on. The combination of the profitability ratios would give a more accurate analysis than using one of these. These profitability ratios are discussed one by one below. For more varied financial ratios, you can access eFinancialModels.
1. Gross Profit Margin
The gross profit margin is computed by dividing gross profit by net sales. It shows that the business can cover the cost of goods sold. In the case of service industries, costs considered are the costs of revenue. A high gross profit rate shows the business operation’s efficiency while a low gross profit rate can reflect short sales, low prices, or a saturated market.
2. EBITDA Margin
EBITDA is derived by subtracting from the gross profit the salaries & wages, rent, utilities, supplies, and other costs related to production except for the interest expense and taxes. In addition, depreciation & amortization is excluded as well (or added back in case the expenses include those items. The EBITDA margin is computed by dividing the EBITDA by net sales and reflects the cash operating profit of the business. This financial ratio can compare one business to another since it only includes the operational costs on a cash basis and disregards the debt financing, which can be different from one company to another.
3. Net Profit Margin
The net profit can be seen in the bottom part of the income statement. It is computed after deducting all the expenses, including the interest expenses and taxes, depreciation, and amortization. Companies used this profitability ratio to measure how the business is performing after considering all the costs. On the downside, the net profit margin is not an excellent financial tool to use compared to other profitability ratios since every business has different financial structures.
4. Operating Cash Flow Margin
The operating cash flow margin is a profitability ratio that shows how efficient the business is in converting its sales into cash. The operating cash flow margin adds back the non-cash expenses depreciation and amortization. Since the company’s revenue drives the operating cash flow, production cost, and overhead, it can be a good measure to compare it to competitors. An increasing operating cash flow margin throughout the years indicates that the business’s performance is improving over time.
5. Return on Assets (ROA)
The return on assets measures the capacity of the business to generate profit with its assets. It is computed by taking the net earnings + interest then divided by the total assets. The higher the ROA is, the more capable the company is in utilizing its investment and turning it into profit. Asset-intensive companies such as car manufacturers and telecommunication services need significant investment to generate income, making a return on assets evaluation more useful.
6. Return on Equity (ROE)
It measures how efficient the investors’ equity is in generating earnings. The ROE is looked at as the shareholders’ point of view in which it is favorable for them to have a higher return on equity since it means a higher return on investment. This financial tool does not take into account the capital invested by bondholders. Having a high ROE would entail that the company can finance expansion internally and less need debt financing.
7. Return on Capital Employed (ROCE)
Return on capital employed measures how efficient the capital is in generating profit. ROCE utilizes EBIT or the company’s earnings. Capital employed is composed of the shareholders’ equity and long-term debt. This financial ratio is useful for companies that are capital intensive like automobile manufacture and telecoms to measure how efficient the capital invested in generating profit. ROCE is also more helpful for businesses financed from equity and debt since it includes the latter in the computation. This financial ratio is more meaningful to look at in assessing returns for a business venture.
8. Dividend Yield
It is shown as the percentage of dividends paid to shareholders divided by the current market price. Mature companies are the ones that pay higher dividend yield compares to new companies. The increased dividend yield does not always mean a high actual amount of dividend payments since the fall of stock prices can result in a high percentage of dividend yield. The rise of the stock price can lower the dividend yield, given that dividends’ value is the same.
9. Price/Earnings Ratio (P/E Ratio)
As the name implies, it is computed by dividing the stock price by earnings per share. The price/earnings ratio is used to evaluate stocks compared to the company’s earnings, which means that it is the price the investors are willing to pay by investing in a particular stock. Companies that have more potential for growth, like the technology companies, have a higher P/E ratio since investors are willing to invest that much price expecting a high return in the future.
EBITDA is the earnings before interest, tax, depreciation and amortization, while EV is the enterprise value. This financial ratio is used to determine the company’s profits concerning the company’s enterprise value. It disregards the interest and tax in the computation since it does not affect its actual profitability and excludes the effect of financial leverage. Profit is calculated before subtracting for depreciation and amortization which in many cases are subject to manipulation and distortions of the real profitability.
Financial analysts and investors utilize the combinations of the above financial ratios to evaluate business profitability and which specific investments would be more profitable than the other. Using as many financial ratios will provide more comprehensive and reliable results for the business.