“Profitability ratios are a class of financial metrics that are used to assess a business's ability to generate earnings as compared to its expenses and other relevant costs incurred during a specific period of time.” (Investopediab, 2016) The majority of these ratios are based on income or assets, and they are used as indicators of a company’s profitability. Typically, the higher the profitability ratio, the better, and consistently similar ratios over multiple periods are a sign of a healthy business.
Profitability ratios can be incredibly useful when considering possible investments and managerial decisions, but they do require some knowledge of industry standards and GAAP to be effectual. The measure of a good profitability ratio varies with industry, business model, and season, and ratios can be manipulated by companies that tinker with their books or markets. It is important to understand how to recognize these variables and assess their impact on financial metrics, rather than relying simply on ratios to make business decisions. For the purposes of this discussion we will focus on four of the most commonly utilized profitability ratios, profit margin, net profit margin, return on assets, and return on equity.
Gross Profit Margin: Gross Profit/Net Sales = ____%
The gross profit margin ratio is a measure of how the cost of goods sold stacks up against sales. Companies use this ratio to manage their inventory and services pricing. A larger gross profit margin is a good sign for businesses.
“The biggest disadvantage of measuring a business with the gross margin ratio is that it does not take all costs into consideration.” (Mulligan, n.d.) General and administrative costs are not factored into the gross profit margins, which would otherwise increase the cost of goods sold and decrease the profit margin. Additionally, gross profit margins do not take into account the liabilities of a company, and a good gross profit margin could indicate a healthy company when that company is actually upside down in debt.
Net Profit Margin: Net Income/Net Sales = _____%
Net profit margin ratios are probably the most common profitability ratio because, unlike gross profit ratios, net profit margin account for expenses like taxes, interest, and depreciation. Net profit margins paint a more complete picture of the profitability of a company, and they represent the actual profit made from every dollar invested. If a company’s net profit margin is 17% that means they make 17 cents on every dollar. It’s very straightforward.
However, there are downsides to net profit margins as well. For instance, “Companies in different industries may often have wildly different business models, such that they may also have very different profit margins, thereby rendering a comparison of their profit margins relatively meaningless.” (Investopediaa, 2016) Comparing net profit ratios to competitors can be a tricky business if those companies’ revenues and business models are dissimilar.
Return on Total Assets: Net Income/Total Assets = _____%
As an alternative to the profit margin ratios discussed previously, return ratios measure how effectively a company utilizes the resources available to it. The return on assets ratio is very common because it is a measure of how effectively companies generate profits from the assets they’ve invested in. It assesses the balance between profits and investment by comparing net income with the amount invested in total assets. The higher the return on total assets percentage, the greater asset-to-profit efficiency.
Once again, the industry and business type of a company determine how this metric should be used. Companies that require large, upfront investments in equipment, facilities, and property may have a lower return on total assets ratios than low-cost startups, while still making more money. The auto industry, for example, requires heavy investing into machinery, facilities, and products their return on total assets ratios are typically lower than other industries, even though their revenues are incredibly high. (Boyte-White, 2015)
Return on Equity: Net Income/Stockholder's Equity = _____%
For many investors, the return on equity is the most significant ratio to monitor. The return on equity ratio measures how much of a return investors will receive on their investments. Investors look at this ratio first to determine the profitability of investing in a company. Typically, a high return on equity is a good sign for investors and a low return on equity would be a sign of a poor management. However, there are exceptions to that rule, and it all depends on how conservative a company’s business model is. For example,
Return on equity is one of the most utilized profitability ratios to determine a company’s financial position, but it is also one of the easiest to manipulate. (Financial Web, n.d.) Companies can devalue, or write-down, their assets because they are above market value, which increases return on equity accordingly, even though nothing has changed. Common stock can also be bought back from the market to reduce shareholders’ equity, dramatically improving the return on equity ratio. It is important to rely on more than just a solid return on equity to make a business decision.
Tying it All Together
Overall, every financial metric has its pro’s and con’s. The important thing to remember is that they’re most effective when used in conjunction with other metrics. Additionally, using historical data to detect and monitor certain trends in financial analysis ratios can provide insight into increasing or deteriorating profits.