What is Profitability Ratio
Profitability ratio is a general term for various types of financial ratios that measure the company’s ability and efficiency to generate profit from its resources. The profitability ratios show how well an organization uses its internal resources to generate returns which directly reflects the management ability.
The profitability ratio can be categorized into 2 groups the return ratio and the margin ratio. The return ratio such as return on assets, return on equity, return on capital employed, and return on invested capital indicate the company’s ability to generate returns by utilizing the related resource. The margin ratio such as operating margin, net profit margin, gross profit margin, profit margin, EBIT, EBITDA, and cash flow margin indicates the company’s ability to convert sales into profits.
There are the 6 common profitability ratios to measure the company’s ability to generate profit:
- Return on Equity (ROE) measures the company’s ability to generate income by using the shareholders’ equity.
- Net Profit Margin (NPM) measures the operating effectiveness by reflecting the number of profits earned per dollar of sales.
- Return on Assets measures the amount of net income that the business generated by each dollar of its assets.
- Earnings per Share (EPS) measure the net income earned for each common stock.
- Return on Capital Employed (ROCE) measures the company’s ability to utilize capital invested to generate the return.
- Operating Margin measures the number of profits that the company earned per dollar of sales after expenses.
Return on Equity (ROE)
The return on equity (ROE) measures the company’s profitability by utilizing the shareholders’ equity. The return on equity shows how many dollars of net income a company generated for each dollar of the owner’s equity. The return on equity is a comparison between net income and average shareholders’ equity amount, which is can be calculated by the following ROE formula:
- ROE = (Net income / Average shareholders’ equity) x 100
The higher percentage of ROE indicates the company had a high ability to generate profit by utilizing the shareholders’ equity and vice versa.
Return on Capital Employed (ROCE)
The return on capital employed (ROCE) measures the company’s ability to generate profit by using the capital invested in the business. The return on capital employed (ROCE) determines the amount of profit for each dollar of invested capital. The return on capital employed can be calculated by dividing the company’s profit after tax (EBIT) by the capital employed as the following formula:
- ROCE = (EBIT ÷ Capital employed) x 100
The higher return on capital employed ratio, the more profit generated from its invested capital.
Return on Assets (ROA)
The return on assets (ROA) measures the company’s profitability from operating the business. The return on assets indicates the amount of net income that the business generated by each dollar of its assets. ROA can be calculated by dividing net income by average total assets as the following formula:
- ROA = Net Income ÷ Average Total Assets
A higher value of the return on assets (ROA) suggests favorable efficient use of assets to generate income.
Net Profit Margin
The net profit margin is a profitability ratio that measures the operating effectiveness of management by comparing net income with net sales. The ratio expresses as a percentage to reflect the number of profits earned per dollar of sales. The net profit margin can be calculated by dividing the net income (or EBIT) by the net sales as the following formula:
- NPM = (Net income / Net sales) x 100
The higher value of the net profit margin shows the effectiveness of management and vice versa.
Operating Margin
The operating margin is a profitability ratio that measures the number of profits that the company earned per dollar of sales after expenses, also known as the return on sale (ROS) and the profit margin. The operating margin can be computed by dividing the EBIT by the net sales as the following formula:
- Operating margin = (EBIT / Net sales) x 100
The higher percentage of the operating margin shows the more profit that the company generated profit from sales.
Earnings per Share (EPS)
The earnings per share (EPS) measure the net income earned for each common stock, it shows how much money a company made in a specific time period compared to how much investors put in. The earnings per share (EPS) can be calculated by dividing the net income available to common shareholders by the weighted average common shares outstanding as the following formula
- EPS = (Net Income – Preferred Dividends) / Average common shares outstanding
The higher earnings per share, the higher profits to shareholders. Additionally, the good value of earnings per share (EPS) should increase annually.
