Profitability Ratios: Calculation & Analysis

The Purpose of Ratio Analysis

Before we start calculating, it's important to understand what ratios are for and what their limitations are. A ratio on its own is just a number. Its power comes from comparison—against the company's own past performance, against its competitors, or against industry benchmarks.

The following brief reading from AccountingCoach provides a concise overview of the benefits and limitations of financial ratio analysis.

The Two Faces of Profitability: Margins and Returns

Profitability ratios can be broadly grouped into two families, each answering a different fundamental question:

1. Margin Ratios: How much profit does the company make from each dollar of sales? These ratios focus on the Income Statement and assess cost control and pricing power.
2. Return Ratios: How much profit does the company generate from the assets and capital invested in it? These ratios link the Income Statement to the Balance Sheet to measure efficiency and shareholder returns.

This infographic provides a great visual summary of the key formulas we'll be covering today.

Margin Ratios: Profitability from Sales

Let's begin with margin ratios. We'll work our way down the income statement, from the "big profit" at the top to the final net profit at the bottom.

• Gross Profit Margin: This ratio measures the profitability of a company's core business activity. It tells us the percentage of revenue left after accounting for the cost of goods sold (COGS). A high gross margin indicates that the company can produce its goods or services at a relatively low cost. $$\text{Gross Profit Margin}=\frac{\text{Gross Profit}}{\text{Revenue}}\times 100$$
• Operating Profit Margin: This ratio goes a step further by also deducting operating expenses like administration, marketing, and R&D. It reveals the profitability of a company's normal business operations before the effects of interest and tax. This is often seen as a purer measure of operational efficiency, as it isn't affected by how the company is financed or its tax jurisdiction. $$\text{Operating Profit Margin}=\frac{\text{Operating Profit}}{\text{Revenue}}\times 100$$
• Net Profit Margin: This is the "bottom line" margin. It shows the percentage of revenue that is left for shareholders after all expenses, including interest and taxes, have been paid. It represents the ultimate profitability of the company from all its activities. $$\text{Net Profit Margin}=\frac{\text{Net Income}}{\text{Revenue}}\times 100$$

The following video from Accounting Stuff provides excellent, clear walkthroughs for calculating these three margin ratios using a sample company.

Return Ratios: Profitability from Investment

Now we turn to the second family of ratios: returns. These ratios assess how effectively management is using the company's resources (its asset base and its funding) to generate profit.

• Return on Assets (ROA): This ratio measures how efficiently a company uses its total assets (e.g., factories, cash, inventory) to generate profit. It answers the question: "For every dollar of assets the company owns, how many cents of profit does it generate?" $$\text{Return on Assets (ROA)}=\frac{\text{Net Income}}{\text{Total Assets}}\times 100$$
• Return on Equity (ROE): This is a crucial ratio for shareholders. It measures the rate of return on the money that equity investors have put into the business. A high ROE indicates that management is using shareholders' funds effectively to create profit. $$\text{Return on Equity (ROE)}=\frac{\text{Net Income}}{\text{Shareholders’ Equity}}\times 100$$
• Return on Capital Employed (ROCE): This is arguably the most comprehensive return metric. It measures the return generated from all long-term capital invested in the business, including both debt and equity. It compares operating profit (before interest is paid to debtholders) to the total pool of long-term funds. $$\text{Return on Capital Employed (ROCE)}=\frac{\text{Operating Profit}}{\text{Total Assets}-\text{Current Liabilities}}\times 100$$

Let's return to the Accounting Stuff video to see these calculations in action.

Applying the Ratios: A Worked Example

As we've discussed, a ratio is most useful when compared over time. The following image shows a typical summary of a company's profitability analysis, comparing historical performance with a future projection.

Let's use the data for "Historical Year 1" from this image to practice the calculations ourselves.

Year 1 Data:

• Sales: $9,188,748
• Gross Profit: $2,343,833
• Net Income: $310,178
• Total Assets: $5,300,000
• Total Owners' Equity: $1,200,000

Calculations:

1. Gross Profit Margin:
   $\frac{\$2,343,833}{\$9,188,748}=0.255=25.5\%$
   This matches the table. For every $100 of sales, the company has $25.50 left after paying for its direct costs.

2. Net Profit Margin:
   $\frac{\$310,178}{\$9,188,748}=0.0337\approx 3.4\%$
   This also matches the table. After all expenses, the company keeps 3.4 cents of every dollar in sales.

3. Return on Equity (ROE):
   $\frac{\$310,178}{\$1,200,000}=0.258\approx 25.8\%$
   Note: The image shows a different "Return on Investment" calculation, which is likely ROA. Let's calculate both ROE and ROA. An ROE of 25.8% is very strong, suggesting a high return for shareholders.

4. Return on Assets (ROA):
   $\frac{\$310,178}{\$5,300,000}=0.0585\approx 5.9\%$
   This matches the "Return on Investment" figure in the table. The company generates about 6 cents of profit for every dollar of assets it controls.

Notice the significant difference between ROA (5.9%) and ROE (25.8%). This indicates the company is using a substantial amount of debt (leverage) to finance its assets. We will explore leverage ratios in a future lesson.

For a more detailed look at comparing ratios year-on-year, the following video provides another worked example. The calculations are slightly more advanced, as the instructor uses average balance sheet figures, which is a common practice for improving the accuracy of return ratios.

Conclusion

In this lesson, we have laid the groundwork for interpreting financial statements by calculating and analysing key profitability ratios. You have learned how to measure a company's performance from two critical perspectives: its ability to generate profit from sales (margins) and its efficiency in using its capital to generate profit (returns).

Key Takeaways:

• Profitability ratios provide context to a company's profit figures, enabling comparison over time and against peers.
• Margin Ratios (Gross, Operating, Net) measure profitability relative to sales and are found by analysing the Income Statement.
• Return Ratios (ROA, ROE, ROCE) measure profitability relative to the investment base and connect the Income Statement with the Balance Sheet.
• Gross Profit Margin reflects the profitability of core production.
• Operating Profit Margin shows the efficiency of normal business operations.
• Net Profit Margin is the "bottom line" profitability for shareholders.
• Return on Assets (ROA) measures the efficiency of asset utilisation.
• Return on Equity (ROE) is a key measure of returns generated for the company's owners.

In our next lesson, we will continue our journey into ratio analysis by focusing on liquidity. Having established how to measure if a company is profitable, we will next ask: does it have enough cash to pay its bills on time?