Written by Gregory Steffens for Gaebler Ventures
To effectively evaluate a company's successfulness at generating returns and profits from its operating investments, one must utilize profitability ratios. This article introduces some key profitability ratios and how they are calculated.
Profit margin, return on assets, and return on equity measure a firm's performance in various areas of its operations.
Let's take a look at the most common profitability ratios.
Net Profit Margin
A company's net profit margin measures its ability to remain profitable during adverse conditions like falling sales, falling prices, or decreasing sales in the future. The resulting number shows the percentage of every dollar in sales that becomes profit for the company.
The higher the percentage, the better the company is at managing costs. Because the average profit margins differ between industries, net profit margin should be used to compare companies within the same industry or sector. It can also be used to evaluate the profitability of a company over time by comparing historical profit margin numbers to recent ones.
Also referred to as return on sales, net profit margin is calculated by dividing a firm's net income after taxes and interest by its net sales. One then multiplies the resulting number by one hundred to discover what percentage of revenue from each dollar in sales translates into profit for the company.
Included with the financial statements released with the quarterly and annual reports, both net income and sales can be found on a firm's income statement. If the net profit margin is sixty-seven percent, the company profits sixty-seven cents from each dollar in sales.
Return on Assets (ROA)
The return on assets ratio measures a firm's ability to effectively and efficiently implement its assets to generate profits. A ROA number gives the percentage of profits earned for each dollar of a company's assets. The higher the ROA percentage, the better the company is at utilizing its assets to generate income. As with other ratios, ROA should be compared to a firm's historical numbers or the ratios of competitors in the same industry to have the most meaning.
ROA is calculated by dividing a firm's net income after taxes and interest by its total assets and then multiplying that number by one hundred. While the net income comes from the income statement, a firm's total assets can be found on its balance sheet. If the ROA is two percent, the company makes two percent profit on the assets it uses in its operations.
Return on Equity (ROE)
Also known as return on net worth, return on equity measures a firm's ability to generate returns from capital invested by its shareholders. ROE gives the percentage of shareholder's equity that the company translates into profits. Although a larger number is always better, an acceptable ROE usually is ten percent or above.
Again, like the profit margin and ROA ratios, ROE should be compared to the company's historical numbers or to competitors in the same industry or sector.
To calculate ROE, one takes a firm's net income after taxes and interest, divides it by total shareholder's equity, and multiplies that number by one hundred. While the net income is found on the income statement, the firm's total shareholder's equity is stated on the balance sheet of the firm's financial statements. If the ROE for a company is three and a half percent, the company generates a three and a half percent return on the capital invested by its shareholders.
Gregory Steffens is a talented writer with a strong interest in business strategy and strategic management. He is currently completing his MBA degree, with an emphasis in finance, at the University of Missouri.
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