Profitability Ratios
Profitability ratios measure how effectively a company is generating profits from its operations. Generally, higher profitability ratios mean a company is efficiently generating income from its operations and can therefore generate more returns for its shareholders; while lower profitability ratios typically mean the opposite. The four key profitability ratios include return on assets (ROA), return on equity (ROE), gross profit margin, and operating profit margin.
Return on Assets (ROA)
Return on assets (ROA) is used to measure how well a company is using its assets to generate profits. ROA is calculated by taking a company’s net income and dividing it by its total assets. A higher ROA indicates that a company is generating more income from its assets, while a lower ROA indicates that a company is not efficiently using its assets to generate income.
Return on Equity (ROE)
Return on equity (ROE) is used to measure a company’s profitability based on its ownership equity. ROE is calculated by taking a company’s net income and dividing it by its shareholders’ equity. A higher ROE indicates the company is efficiently using the money it gets from its shareholders to generate income, while a lower ROE indicates the company is not efficiently using the money it gets from its shareholders to generate income.
Gross Profit Margin
Gross profit margin is used to measure the profitability of a company’s sales. Gross profit margin is calculated by taking a company’s sales revenue and subtracting the cost of goods sold (COGS). The resulting number is then divided by the sales revenue. A higher gross profit margin indicates the company is efficiently producing items and generating income from them, while a lower gross profit margin typically indicates the company is not producing the items efficiently or not generating enough income from them.
Operating Profit Margin
Operating profit margin is used to measure a company’s profitability from its operations. Operating profit margin is calculated by take a company’s operating income and dividing it by its total revenue. Operating income only includes income generated from regular operations and excludes income generated from investments or non-operating activities. A higher operating profit margin indicates the company is efficiently operating and generating income, while a lower operating profit margin typically indicates the company is not efficiently operating or not generating adequate income from its operations.
Profitability ratios provide investors and potential investors with an indication of how efficiently a company is generating profits from its existing operations. By understanding the different profitability ratios and how they are calculated, investors can gain insight into how well the company is performing with regard to its profitability and make more informed decisions on whether or not to invest.
