Profitability Ratios

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All companies are concerned about their business profitability in order to keep it running. It is the lifeblood of any business. Most of the time, it is how they measure the success of their business. They use financial tools such as profitability ratios to determine their performance by calculating their financial bottom lines and how much equity their investors can get out of it.

There are two types of profitability ratios: margin ratios and return ratios. Margin ratios illustrate the company’s capability to convert sales money into profits at different stages, while returns ratio illustrates the business’ capacity to measure the effectiveness and proficiency of the company in producing returns for all its shareholders. Now let us interpret each ratio under these two types.

Margin Ratios

  1. Operating Profit Margin

This is also known as earnings before interest and taxes or EBIT.  It also demonstrates the percentage of sales as operating profit margin ratio measures the company’s overall efficiency in integrating all the operational cost of the business on the daily. The variable costs include the daily wage of its workers, raw materials, and other standard operational expenses.

Operating Profit Margin: EBIT/Net Sales = ____________%

Both EBIT and Net Sales are taken from the company’s income statement. It means, the more sales money left after covering the daily operational cost of the company left, the more profitable the sales are. The company can use the percentage to manage fixed cost and interest on debt better and to sustain the business in times of economic downturn.

Advantage: Operating margin profitability ratio is useful tool in determining the financial health of the company.

Disadvantage: This profitability ratio also has its limitations. For one, it doesn’t include the investment capital it used when it started. This is essential most specifically to start-up companies working to recover the initial cost of starting up the company. This ratio should only be used to differentiate and compare companies operating in the same industry with the same business model. Also, there can be complications that may emerge such as overhead cost.

  • Gross Profit Margin

This ratio demonstrates the efficiency of the company in controlling the manufacturing and production its products and the cost of all goods and services in its inventory, which they eventually pass on to their customers.

Gross Profit Margin: Gross Profit/Net Sales = ___________%

Both gross profit and net sales are taken from the income statement of the company. The main focus of this ratio is looking at the percentage sales of the goods that are sold. So if you will interpret the result of this, the bigger the gross profit margin, the more advantageous for the company.

Advantage: It is very simple and easy to use in determining the value of the company’s current inventory. It is less time-consuming and it is a great budgeting tool for the company. Companies can benefit from using profitability ratios to quantify or compare the price and how it would affect its profitability. It is a great tool to use in controlling the prices of company goods and services.

Disadvantage: It doesn’t include all cost. It should only be used to measure the company’s operating efficiency because it is hard to gauge if the gross margin is acceptable or not by using this ratio alone. It is difficult to gauge the cost efficiency in understanding sales by using this ratio alone. Companies must have all information of the price level to be able to assess cost-efficiency. Also, it cannot determine the total profit level of the company without taking into consideration the total sales volume.

  • The Cash Flow Margin Ratio

This is an essential part of profitability ratios because it demonstrates the connection between cash produced from sales and operations. For all companies, cash is as important as the profit. Why? Because they have to pay suppliers, service debts, dividends, and upgrade their capital assets to keep the business running.

Cash Flow Margin: Operating cash flow/Net Sales = __________%

The numerator is taken from the company’s Cash Flows Statement, and the denominator, net sales, is taken from the income Statement of the company.

The higher the percentage results, the better. If the result of the equation is negative, it means that even though the business is generating sales, the company is still losing money. The company has to raise money by borrowing from its investors to keep operations. If the result is good, the company can focus more on generating cash flow internally.

Advantage: Using the ratio is effective in constantly improving the company’s performance and it is a clear indication of the company’s capacity to convert sales into cash.

Disadvantage: At times, it could be misleading because a low cash flow does not immediately signals that the company is in trouble. Investors usually look at the cash flow without taking into consideration that sometimes, companies can affect the ratio by extending the time they settle their bills.

  • Net Profit Margin

This is the profitability ratio analysis that companies commonly use when they need a simple analysis. This demonstrates how much of each sale translates as net income after paying all expenses. These expenses include taxes, depreciation, and interest.

Net Profit Margin: Net Income/Net Sales =_________%

Both the numerator and denominator are taken from the company’s income statement. The higher the net profit margin, the company is more efficient in generating sales into profit. The difference of net profit margin to gross profit margin is that net profit margin includes all cost including the fixed cost in the equation.

Advantage: Unlike gross profit margin, this ratio actually includes all cost to get the final computation of the company’s business.

Disadvantage: Although it is simple to use, it only shows short-term measurement because it doesn’t disseminate all of the company’s undertaking to preserve profitability.

Returns Ratios

  1. Return on Equity (ROE)

Of all the financial ratios, investors consider these profitability ratios as the most important one. It simply demonstrates the return of their investment or the money they invested in the company. This is what other prospective investors review and study when they are trying to find profitable stocks and determining if the company is worth their investment and how the company stacks up against its industry rivals.

ROE: Net Income/Stockholder’s Equity = ________%

Net income comes from the company’s income statement and the denominator comes from the balance sheet. Overall, the higher the percentage, the better it is for both the investors and the company.

Advantage: It is a great tool to use to determine if the company is doing a great job in using the investor’s money. If the percentage is low and the company is aiming for new investors, there is a little chance they can get one.

Disadvantage: One factor that leads to the disadvantage of using this ratio is that it is sensitive to leverage. It is because the net income is not always reliable and can be influenced by accounting practices. This makes the return on equity results unreliable, as well. This ratio alone cannot state the real condition of the company. Other ratios must be used in conjunction with return on equity.

  • Return on Assets/Return of Investments

Return on Investments (ROI) is an important ratio because it demonstrates how a company maximizes the use of its resources or assets to generate profit. It measures the total sum of profit earned corresponding to the company’s investment in total assets.

ROI: Net Income/Total Assets = _________%

The numerator or net income comes from the company’s income statement and the denominator, total assets, is taken from the company’s balance sheet.

If the equation results in a larger percentage, it means that the company is doing a great job in generating sales by utilizing all its assets.

Advantage: this ratio includes a clear data of profitability; it shows the company’s ability to achieve its goals, a great tool in the comparative analysis, and a clear measure of the investment division’s performance.

Disadvantage: the return of investment ratio has some limitations. Companies must use similar accounting methods and policies when comparing the return on investment. Also, a divisional manager may only select investments with high return rates that are above his target ROI. This can distort the company’s overall records.

  • Cash Return on Assets

This ratio is usually used in a more advanced analysis of profitable ratio. Cash return on assets is used to compare to return on investment ratio because it is specified on an increasing basis or accrual.

Cash Return on Assets: Operating activities cash flow/Total Assets = ________%

The numerator comes from the company’s statement of cash flows and the denominator is taken from the balance sheet. As in most ratios, the favorable the percentage results are, the better.

Advantage: It is specifically designed to demonstrate the difference between the company’s net income and cash flow. It is a more accurate ratio to use in the computation of ROA than net income.

Disadvantage: the result can be very misleading if it is evaluated without adequate context especially for asset-heavy industries.

The truth is, each ratio analysis has its own advantages and disadvantages. There is no single metric that can demonstrate how one company is doing overall, but considering each ratio can provide the company and its investors a clear picture of how the company is doing compared to its competitors.

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