What Are Profitability Ratios?

Profitability ratios are used to assess a business's ability to generate earnings over time relative to its revenue, operating costs, balance sheet assets, or shareholders' equity. They are a cornerstone of 澳洲幸运5官方开奖结果体彩网:financial analysis.

There are many ways to assess a company's profitability, but most profitability ratios fall into one of two broad categories—margin ratios and return ratios.

Profitability ratios are often used alongside 澳洲幸运5官方开奖结果体彩网:efficiency ratios, which consider how📖 well a company uses its assets internally to generate income (as opposed to after-cost profits).

What Can Profitability Ratios Tell You?

Profitability ratios can shed light on how well a company's management is operating a business. Investors can use them, along with other research, to determine whether or not a company might be a good investment.

Broadly speaking, higher profitability ratios can point to strengths and advantages that a company has, such as the ability to charge more (or less) for produ🅰cts andཧ to maintain lower costs.

A company's profitability ratios are most useful when compared to those of similar companies, the company's own performance history, or average ratios for the company's industry. Normally, a higher value relative to previous value indicates that the company is doing well.

Types of Profitability Ratios

Profitability ratios gen🦋erally fall into two🐈 categories—margin ratios and return ratios.

Margin ratios give insight, from several different angles, into a company's ability to turn sales into profit. Return ratios offer several different ways to examine how well a company generates a return for its shareh💙olders using the money they've invested.

Some common examples of the two typeไs of profitability ratios are:

• Gross margin
• Operating margin
• Pretax margin
• Net profit margin
• Cash flow margin
• Return on assets (ROA)
• Return on equity (ROE)
• 澳洲幸运5官方开奖结果体彩网:Return on invested capital (ROIC)

Margin Ratios

Different 澳洲幸运5官方开奖结果体彩网:profit margins are used to measure a company's profitability at various cost levels of inquiry. These 澳洲幸运5官方开奖结果体彩网:income statement profit margins include gross margin, operating margin, pretax margin, and net profit margin. The margins between profit and costs expand when costs are low and shrink as layers of additional costs (e.g., 澳洲幸运5官方开奖结果体彩网:cost of goods sold (COGS), operating expenses, and taxes) a🧔re taken iꦅnto consideration.

Gross Margin

Gross profit margin, also known as gross margin, is one of the most widely used profitability ratios. Gross profit is the difference between sales revenue and the costs related to the products sold, the aforementioned COGS. 澳洲幸运5官方开奖结果体彩网:Gross margin compares gross profit to revenue.

A company with a high gross margin compared to its peers likely has the ability to charge a premium for its products. It may indicate the company has 澳洲幸运5官方开奖结果体彩网:an important competitive advantage. On the 🌌other hand, a pattern𝔉 of declining gross margins may point to increased competition.

Some industries experience 澳洲幸运5官方开奖结果体彩网:seasonality in their operations. For example, retailers typically experience significantly higher revenues and earnings during the year-end holiday season. Thus, it would be most informative and useful to compare a retailer's fourth-quarter profit margin with its (or its peers') fourth-quarter profit margin from the previous year.

Operating Margin

澳洲幸运5官方开奖结果体彩网:Operating margin is the percentage of sales left after accounting for COGS as well as normal o🐼perating expenses (e.g., sales and marketing, general expenses, administrativ𒆙e expenses). It compares operating profit to revenue.

Operating marginꦓ can indicate how efficiently a company manages its operations. That can provide insight into how well those in management keep costs down and maximize profitability.

A company with a higher operating margin than its peers can be considered to have more ability to handle its fixed costs and interest on obligations. It most likely can charge less than its competitors. And it's better positioned to weather the effects of a slowing economy.

Pretax Margin

The 澳洲幸运5官方开奖结果体彩网:pretax margin shows a company's profitability after accounting for all expeꦐnses including non-operating expenses (e.g., interest payments and inventory🌟 write-offs), except taxes.

As with other margin ratios, pretax margin compares revenue to costs. It can signal management's ability to run a business efficiently and effectively by boosting sales as it lowers costs.

A company with a high pretax profit margin compared to its peers can be considere♈d a financially healthy company with the ability to price its products and/or services most appropriately.

Net Profit Margin

The澳洲幸运5官方开奖结果体彩网: net profit margin, or net margin, reflects a company's ability to generate earnings after all expenses and t🤪axes are accounted for. It's obtained by dividing net income𒁃 into total revenue.

Net pr𒐪ofit margin is seen as a bellwether of the overall financial well-being of a business. It can indicate whether company management is generating enough profit from its sales and keeping all cost🎀s under control.

Its drawback as a peer comparison tool is that, because it accounts for all expenses, it may reflect one-time expenses or an asset sale that would increase profits for just that period. Other companies won't have the same one-off transactions. That's why it's a good idea to look at other ratios, such as gross margin and operating margin, along with net profit margin.

Cash Flow Margin

The cash flow margin measures how well a company converts sales revenue to caꦫsh. It reflects the relationship between cash flows from operating activities and sales.

Cash flow margi𓂃n is a significant ratio for companies because cash is used to buy assets and pay expenses. That makes the management of cash flow very important. A greater cash flow margin indicates a greater amount of cash that can be used to pay, for example, shareholder dividends, vendors, and debt payments, or to purchase capital assets.

A company with negative cash flow is losing money despite the fact that it's producing revenue from sales. That can mean that it might need to borrow funds to keep operating.

🦩 A limited period of negative cash flow can result from cash being used to invest in, e.g., a major project to support the growth of the company. One could expect that th📖at would have a beneficial effect on cash flow and cash flow margin in the long run.

Return Ratios

Return ratios provide information that can be used to evaluate how well a company generates returns and creates wealth for its shareholders given a certain level of investment deployed to generate such profits. These profitability ratios compare investments in assets or equity to net income. Those measurements can indicate a company's capability to manage these investments.

Return on Assets (ROA)

Profitability is assessed relative to costs and expenses. It's analyzed in comparison to assets to see how effective a company is at deploying assets to generate sales and profits. The use of the term "return" in the ROA measure customarily refers to net profit or 澳洲幸运5官方开奖结果体彩网:net income—the value of earnings from sales after꧟ all costs, expenses, a𓄧nd taxes. ROA is net income divided by total assets.

The more assets that a company has amassed, the greater the sales and potential profits the company may generate. As 澳洲幸运5官方开奖结果体彩网:economies of scale help lower costs and improve margins, returns may grow at a fas🍌ter rate than assets, ultimately increasing ROA.

Return on Equity (ROE)

ROE is a key ratio for 澳洲幸运5官方开奖结果体彩网:shareholders as it measures a company's ability to earn a return on its equity investments. ROE, calculated as net income divided by shareholders' equity, may increase without additional equity investments. The ratio can rise due to higher net income being generated from a larger 澳洲幸运5官方开奖结果体彩网:asset base funded with debt.

A high ROE can be a sign to investors that a company may be an attractive investment. It 💝can indicate that a𝓀 company has the ability to generate cash and not have to rely on debt.

Return on Invested Capital (ROIC)

This return ratio reflects how well a company puts its capital from all sources (including bondholders and shareholders) to work to generate a return for those investors. It's considered a more advanced metric than ROE because it involves more than just shareholder equity—it considers all the capital that is being used by the company to generate the profits.

ROIC compares after-tax operating profit to total invested capital (again, from debt and equity). It's used internally to assess appropriate use of capital. ROIC is also used by investors for valuation purposes. ROIC that exceeds the company's weighted average cost of capital (WACC) can indicate value creation and a company that can trade at a premium.

The Bottom Line

Profitability ratios offer companies, investors, and analysts a way to assess various aspects of a company's financial health. There are two main types of profitability ratios: margin ratios and return ratios.

Margin ratios measure a company's ability to generate income relative to costs. Return ratios measure how well a company uses investments to generate returns—and wealth—for the company and its shareholders.