Profitability ratios are a class of financial metrics that are used to assess a business’s ability to generate earnings relative to its associated expenses. For most of these ratios, having a higher value relative to a competitor’s ratio or relative to the same ratio from a previous period indicates that the company is doing well.
BREAKING DOWN ‘Profitability Ratios’
Some industries experience seasonality in their operations. The retail industry, for example, typically experiences higher revenues and earnings for the Christmas season. It would not be useful to compare a retailer’s fourth-quarter profit margin with its first-quarter profit margin. Comparing a retailer’s fourth-quarter profit margin with the profit margin from the same period a year before would be far more informative.
Some examples of profitability ratios are profit margin, return on assets (ROA) and return on equity (ROE). Profitability ratios are the most popular metrics used in financial analysis. Read the short guide on Profitability Indicator Ratios: Introduction.
Different profit margins are used to measure a company’s profitability at various cost levels, including gross margin, operating margin, pretax margin and net profit margin. The margins shrink as layers of additional costs are taken into consideration, such as cost of goods sold (COGS), operating and nonoperating expenses, and taxes paid. Gross margin measures how much a company can mark up sales above COGS. Operating margin is the percentage of sales left after covering additional operating expense. The pretax margin shows a company’s profitability after further accounting for nonoperating expense. Net profit margin concerns a company’s ability to generate earnings after taxes.
Return on Assets
Profitability is assessed relative to costs and expenses, and it is analyzed in comparison to assets to see how effective a company is in deploying assets to generate sales and eventually profits. The term return in the ROA ratio customarily refers to net profit or net income, the amount of earnings from sales after all costs, expenses and taxes. The more assets a company has amassed, the more sales and potentially more profits the company may generate. As economies of scale help lower costs and improve margins, return may grow at a faster rate than assets, ultimately increasing return on assets.
Return on Equity
ROE is a ratio that concerns a company’s equity holders the most, since it measures their ability of earning return on their equity investments. ROE may increase dramatically without any equity addition when it can simply benefit from a higher return helped by a larger asset base. As a company increases its asset size and generates better return with higher margins, equity holders can retain much of the return growth when additional assets are the result of debt use.