The financial ratios of profitability are those that allow evaluating the profits of the company with respect to the sales, assets or investment of the owners.
Cost effectiveness
Quality of a business to provide an attractive return, that is, the profit or utility that an investment produces.
Profitability reasons
The following are generally used:
Gross profit margin
It measures the percentage that remains of each dollar of sales after the company paid for its goods. The higher the gross profit margin, the better (since the relative cost of the merchandise sold is less). The gross profit margin is calculated as follows:
Gross profit margin = (Sales - Cost Cost of goods sold) / Sales
Gross profit margin = Gross profit / Sales
Operating profit margin
Measures the percentage of each dollar of sales that remains after all costs and expenses have been deducted, excluding interest, taxes, and preferred stock dividends. Represents the "pure profits" earned for each dollar of sale. Operating income is "pure" because it measures only the profit earned on operations and ignores interest, taxes and dividends on preferred shares. A high operating profit margin is preferred. The operating profit margin is calculated as follows:
Operating profit margin = Operating profit / Sales
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Net profit margin
This is the "bottom line" of the operations. The net profit margin indicates the profit rate obtained from sales and other income. The net profit margin considers profits as a percentage of sales (and other income). Because it varies with costs, it also reveals the type of control management has over the company's cost structure.
It is calculated as follows:
Net profit margin = Net profit after tax / Total Sales
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Return on assets, ROA
Return on assets (ROA) considers the amount of resources needed to support operations. Return on assets reveals the effectiveness of management in generating profits from the assets available to it and is perhaps the single most important measure of individual return.
ROA is calculated as follows:
ROA = Net profit after tax / Total assets
To make the most of ROMA, we must divide it into its component parts. ROA is made up of two key components: the company's net profit margin and its turnover of total assets.
ROA = Net profit margin x Rotation of total assets
Total asset turnover indicates how efficiently assets are used to support sales. It is calculated as follows:
Rotation of total assets = Annual sales / Total assets
Then you have to:
ROA = (Net profit after tax / Total Sales) x (Annual sales / Total assets)
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Return on capital, ROE
A measure of the company's overall return, return on equity (ROE), is closely watched by investors because of its direct relationship to the company's earnings, growth and dividends. Return on Capital, or Return on Investment (ROI) as it is sometimes called, measures return to equity for the company by relating earnings to shareholder capital:
ROE = Net Income after Tax / Shareholder Capital
Like ROA, the measure of return on capital (ROE) can be divided into its component parts. In reality, ROE is nothing more than an extension of ROA. It introduces the company's financing decisions into the performance analysis, that is, the expanded measure of ROE indicates the degree to which financial leverage (or "profitable use of borrowed capital") can increase return for shareholders. The use of debt in the capital structure means, in fact, that ROE will always be greater than ROA. The question is how much. Instead of using the shortened version of ROE, that is, the equation above, we can calculate ROE as follows:
ROE = ROA x Capital multiplier
Where the capital multiplier is:
Capital multiplier = Total assets / Total shareholder capital
Earnings or earnings per share, UPA or GPA
In general, the company's earnings per share (GPA) are important to current or future shareholders, and to management. As mentioned above, GPAs represent the dollar amount earned during the period for each outstanding common share. Earnings per share are calculated as follows:
Earnings per share = Earnings available to common shareholders / Number of common shares outstanding
DuPont Analysis
The DuPont formula can also be included as one of the profitability measures, although it is more a system of analysis of the financial situation of the company. See more in What is the DuPont financial analysis system?
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In the following video-lesson Professor Sotero Amador Fernández, from CEF, explains the financial reasons for profitability, how they are calculated and interpreted.
Bibliography
- Gitman, Lawrence J. and Joehnk, Michael. Investment fundamentals. Pearson Education, 2009.Gitman, Lawrence J. and Zutter, Chad J. Principles of Financial Management. Pearson Education, 2012.
