As the name suggests, profitability ratios help you understand how effective your company is at generating a profit. And though there are many of them, we’ll focus on just five of them. These are the ratios that are the most important, because they’re the ones that businesspeople use the most.
Gross Margin
Gross profit is equal to revenue, which is also known as sales, minus cost of goods sold, or COGS. And from there, we can determine the gross profit margin percentage, or gross margin. Gross margin is simply gross profit divided by revenue, with the result expressed as a percentage.
So, with that said, let’s look back at the income statement that we used to create the cash flow statement. In fact, we’ll use those financial statements to calculate all five of the ratios. In this case, the calculation for gross margin looks like this:
gross margin = gross profit / revenue (sales) = $2,000 / $8,000 = 0.25 = 25%
Now, gross margin shows the basic profitability of your products themselves, before indirect expenses such as rent and utilities are subtracted. In other words, it tells you how much of every sales dollar you get to use in your business. And in this example, that would be 25 cents.
Indirectly, then, it also tells you how much you pay out in cost of goods sold, which are direct costs. These are the costs you incur just to get your products produced. And in this example, that would be 75 cents.
As such, gross margin is a key measure of your company’s financial health. After all, let’s say that you can’t deliver your products at a price that’s high enough above cost to support the rest of your company. If that’s the case, then you won’t have a chance to earn a net profit.
One Thing to Keep in Mind
Now, trends in gross margin are also important, because they may indicate that your company has problems. For instance, let’s say that you achieved great sales numbers in one quarter. But at the same time, you’ve discovered that your gross margins are actually heading downward.
“How can this be?” you ask.
Well, in this case, you may have been doing significant discounting to record the sales numbers that you did. You see, in general, a downward trend in gross margin means one of two things. Or both.
Either you’re facing severe price pressure and as a result, you’re being forced to discount. Or, your materials and labor costs are rising, which is driving up your COGS.
As such, gross margin is like an early-warning light, indicating unfavorable trends in your business environment.
Operating Margin
Operating profit margin percentage, or operating margin, is a more inclusive measure of your company’s ability to generate profit.
Now, operating profit is also known as earnings before interest and taxes, or EBIT. And operating profit is equal to gross profit minus operating expenses. So, the amount of operating profit shows you how well your company is running its entire business from an operational point of view.
And from there, operating margin is just operating profit divided by revenue, with the result expressed as a percentage. That being said, the calculation looks like this:
operating margin = operating profit (EBIT) / revenue = $700 / $8,000 = 0.0875 = 8.75%
Now, operating profit can be a key metric for many managers to watch. And the reason for this is because nonfinancial managers don’t have much control over two other items: interest and taxes. You see, these are the two items that are eventually subtracted from operating profit to get net profit.
So, operating margin is a good indicator of how well most managers as a group are doing their jobs. As such, a downward trend in operating margin is also a warning signal. And that’s because it indicates that costs and expenses are rising faster than revenues, which is rarely a good sign.
Now, as with gross margin, it’s easier to spot trends in operating results when you’re looking at percentages instead of actual numbers. After all, a percentage change shows you not only the direction of the change, but also how great the change is.
Net Margin
Net profit margin percentage, or net margin, tells you how much out of every sales dollar your company gets to keep after everyone else has been paid. For instance, these include your employees, vendors, lenders, and the government.
Net margin is also known as return on sales, or ROS. And it’s just net profit divided by revenue, expressed as a percentage. So, the calculation looks like this:
net margin (ROS) = net profit / revenue = $200 / $8,000 = 0.025 = 2.5%
Now, since net profit is also known as the bottom line, net margin is also known as the bottom-line margin. With that said, though, net margins can be highly variable from one industry to another.
As such, the best point of comparison for net margin is your company’s performance in prior time periods. Or, you can also look at your performance relative to similar companies in your industry.
Okay. With the three ratios that we’ve looked at so far, they use numbers from the income statement alone. Now, we’ll introduce two different profitability ratios which come from both the income statement and the balance sheet.
Return on Assets
Return on assets, or ROA, tells you what percentage of every dollar invested in your company was returned to you as profit. You see, every business puts certain assets to work.
For instance, cash, facilities, computers, equipment, vehicles, and inventory are common examples. And all of these assets show up on the balance sheet.
So, the total assets figure shows you how many dollars, in its various forms, are being used in your business to generate profit. From there, ROA shows you how effective your company is at using those assets to generate profit.
Now, the nice thing about ROA is that it can be used in any industry. And, it can also be used to compare the performance of one company with other companies of different size.
So, before we move on, remember that we’ll look at the income statement that we used to create the cash flow statement mentioned above to calculate this ratio. And this time, we’ll also look at the related balance sheet that was used to create the cash flow statement as well.
With that said, the formula and calculation for ROA looks like this:
return on assets = net profit / total assets = $200 / $4,900 = 0.0408 = 4.08%
One Important Note
Okay. Now that you know the formula for ROA, there’s one thing that you might find strange about this ratio. You see, when you compare it to the first three ratios that we’ve discussed, it’s hard for gross profit, operating profit, and net profit to be too high.
In other words, you generally want them to be as high as possible. However, that’s not always the case with ROA, which can be too high.
“What do you mean?” you ask. Well, if your return on assets is much higher than the industry norm, it could mean that your company isn’t renewing its asset base for the future. Or, to put it another way, it isn’t investing in things such as new equipment and computers.
And if that’s true, then your company’s hopes for the future won’t look too bright, no matter how good your ROA looks at the moment.
Return on Equity
Return on equity, or ROE, is a bit different than return on assets. And to be more specific, return on equity tells you what percentage of profit you make from every dollar of equity invested in your company.
Remember, the difference between assets and equity is that assets are what your company owns. Equity, on the other hand, is calculated by subtracting your liabilities from your assets.
Now, just like the other profitability ratios, ROE can be used to compare your company with its competitors. And, it can be used to make comparisons with companies in other industries as well.
However, this comparison isn’t always straightforward. For instance, Company A may have a higher ROE simply because it borrowed more money than Company B. In other words, it has more liabilities and much less equity invested in the company.
“Is that good or bad?” you wonder. Well, the answer depends on whether Company A is taking on too much risk. Or whether, on the other hand, it’s using borrowed money prudently to enhance its return.
But either way, here is the formula and calculation for ROE:
return on equity = net profit / owners’ equity = $200 / $2,725 = 0.0733 = 7.33%
Why ROE Matters
Now, from an investor’s point of view, ROE is a key ratio. You see, an investor can earn a certain interest rate by simply investing in securities from the U.S. Treasury. And these are about as close to a risk-free investment as you can get.
So, if someone is going to invest money into your company instead of a security from the U.S. Treasury, she’ll naturally want a higher return on her equity.
To be clear, though, ROE doesn’t specify how much cash she’ll ultimately get out of your company. After all, that depends on your company’s decision about dividend payments, as well as how much the stock price increases before she sells.
But, ROE is still a good indicator of whether your company is even able to generate a return that’s high enough to make it worth whatever risk is involved in investing in your company.
Leave a Reply