Business
Profitability Ratio
Profitability ratio is a financial metric used to evaluate a company's ability to generate profit relative to its revenue, assets, or equity. It provides insight into the efficiency and effectiveness of a business in generating earnings from its operations and investments. Common profitability ratios include net profit margin, return on assets, and return on equity.
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10 Key excerpts on "Profitability Ratio"
eBook - ePub- Richard E. Brown(Author)
- 2017(Publication Date)
- CRC Press(Publisher)
When going through the definitions of financial ratios, it is important to remember that usage in the industry is not always consistent. For example, some sources define the ratio “return on sales” as operating income divided by sales. Others define it as pretax income (IBT) divided by sales. Still others define it as net income divided by sales. To avoid confusion, the remainder of this chapter only provides the most frequently used definition for each financial ratio. When actually examining and using financial ratios, the reader is encouraged to always verify the precise definitions that are being used.To help give the reader a better feel for financial ratios, beyond definitions, typical ratio values are provided. Most are based on 2007 financial statements for all US publicly traded electric utilities and combined electric and gas utilities. The exceptions are market ratios, which are based on traded market values as of January 2009. These data sets are used since they are large and publicly available.6.1 Profitability RatioS
Profitability Ratios reflect how much money a company is making compared to some measure of company size. There are many different Profitability Ratios using different measures of profit for the numerator and different size measures for the denominator. Some of the more common Profitability Ratios are now presented.Gross profit margin, often referred to as gross margin, is the average amount of profit made per sale only considering the direct cost of producing the goods and/or services. In the above equation, operating revenue is equivalent to sales. Sales (operating revenue) minus the cost of goods sold is called gross profit. If gross margin is negative, money is lost on each sale (on average). If gross margin is positive, the company still might not be profitable, but the positive gross margin can be used to pay for non-operational costs such as interest payments.In 2007, the average gross profit margin for publicly traded US energy utilities was 55%, which was identical to the 2006 values. This represents the difference between energy sales and the direct cost of energy, including fuel for electricity generation, purchased gas, and purchased wholesale electricity. Gross profit margin is high, indicating a high amount of incremental profit for additional energy sales. Of course, additional energy sales will eventually lead to the need for additional infrastructure and associated costs.
- Michael Chibili(Author)
- 2019(Publication Date)
- Routledge(Publisher)
All the major stakeholders prefer this ratio to be relatively high. 7.2.3 Profitability Ratios Profitability Ratios are used to measure the business’ ability to generate earnings compared to its expenses and other relevant costs during its operations for a specific period of time. These ratios permit management and owners to compare their performances to that of others within the same property or across companies as well as compare to their own expectations as defined in their budgets. As a primary objective of most hospitality operations is to make profit which can be paid out through dividends or retained in the company as retained earnings, the assessment of a company’s profitability is of primary importance. Creditors always want to notice increases in the company’s profitability soon as this will reduce the risk the creditors bear. Gross return on assets The gross return on assets shows the relationship between the EBIT and the average total assets. It is calculated as follows: EBITDA – cash transfers to replacement reserves Debt service payments EBITDA Debt service payments Operating cash flows Average total liabilities EBIT Average total assets © Noordhoff Uitgevers bv The gross return on assets is expressed as a percentage. It measures the effectiveness of management’s use of the organisation’s assets regardless of financing methods. It is useful in assessing the likelihood of obtaining more debt financing. It is assessed based on industry standards and individual company expectations. Net return on assets The net return on assets is the relationship between net income and average total assets. It is calculated as follows: The net return on assets is equally expressed as a percentage. It evaluates the possibility of seeking for equity financing instead of debt financing. It is a general indicator of the company’s profitability. The net return on assets can equally be calculated by multiplying the profit margin ratio by the asset turnover ratio.
eBook - PDFOperational Profitability
Systematic Approaches for Continuous Improvement
- Robert M. Torok, Patrick J. Cordon(Authors)
- 2002(Publication Date)
- Wiley(Publisher)
First, there is the relationship of a company’s profits to sales, for example, what is the residual return to the business per sales dollar? The second type of measure, return on investment (ROI), relates profits to the investment required to generate them. The fol- lowing section briefly defines these measures and then elaborates on their use in fi- nancial statement analysis. One measure of a company’s profitability is the relationship between the business’s costs and its sales. The greater a company’s ability to control costs in relation to its 66 TYPES OF FINANCIAL STATEMENTS revenues, the more its earnings power is enhanced. The gross profit margin ratio cap- tures the relationship between sales and manufacturing costs. It is a measure of the raw earning power of the company. The net profit margin ratio shows how many dollars of bottom line net income are generated per dollar of sales. This ratio takes into account all expenses and taxes that the business has to pay out, as well as all revenues coming in to the company. The pretax margin ratio is calculated after financing costs (interest) but prior to income taxes. EBT stands for earnings before taxes, and serves as the numera- tor in the formula. The basic earning power ratio shows the earning power of a com- pany’s assets without regard to taxes or financing. This ratio should be examined in conjunction with turnover ratios to help pinpoint potential problems regarding asset management. Return on assets (ROA) measures a company’s performance in using as- sets to generate earnings. In actuality, the number can be interpreted as profit per dol- lar of assets. It should be noted that the ROA measure is sometimes computed “after interest” as either net income or earnings before taxes (EBT) over assets. Preinterest measures of profitability facilitate the comparison of companies with different degrees of leverage.
eBook - PDFFinancial Intelligence for IT Professionals
What You Really Need to Know About the Numbers
- Karen Berman, Joe Knight, John Case(Authors)
- 2008(Publication Date)
- Harvard Business Review Press(Publisher)
To be sure, not all the ratio results we discuss will be similar from one company to another, even in the same industry. For most, there’s a reasonable range. It’s when the ratios get outside of that range, as Sunbeam’s DSO did, that it’s worth your attention. There are four categories of ratios that managers and other stakehold-ers in a business typically use to analyze the company’s performance: prof-itability, leverage, liquidity, and efficiency. We will give you examples in each category. Note, however, that many of these formulas can be tinkered with by the financial folks to address specific approaches or concerns. Tin-kering of this sort doesn’t mean that people are cooking the books, only 147 The Power of Ratios that they are using their expertise to obtain the most useful information for particular situations (yes, there is art even in formulas). What we will provide are the foundational formulas, the ones you need to learn first. Each provides a different view—like looking into a house through win-dows on all four sides. 148 RATIOS 20 Profitability Ratios The Higher the Better (Mostly) P rofitability ratios help you evaluate a company’s ability to generate profits. There are dozens of them, a fact that helps keep the financial folks busy. But here we are going to focus on just five. These are really the only ones most IT managers need to under-stand and use. Profitability Ratios are the most common of ratios. If you get these, you’ll be off to a good start in financial statement analysis. Before we plunge in, however, do remember the artful aspects of what we’re looking at. Profitability is a measure of a company’s ability to gener-ate sales and to control its expenses. None of these numbers is wholly ob-jective. Sales are subject to rules about when the revenue can be recorded. Expenses are often a matter of estimation, if not guesswork.
Available until 8 Dec |Learn more- Walter Reid(Author)
- 2018(Publication Date)
- Routledge(Publisher)
In some businesses, sales, expenses, investment and profits can usefully be analysed on a ‘per employee’ basis or per £ of employees’ costs. Or a retailing operation may want to look at sales revenue and expenses on a ‘per square foot’ basis. The results, as usual, can be compared either over time within a company, or against some external standard (for example foreign competition). MANAGEMENT ACTION TO IMPROVE PERFORMANCE 25 RATIO CALCULATION After you have studied the diagram showing the ‘pyramid’ of ratios, and noted the links between various parts, the next step is to calculate a set of financial ratios for yourself. When approaching the detailed ratio analysis of a company’s accounts, it is helpful to group the ratios under three broad headings to measure different facets of the business: • performance ratios • financial status ratios • stock market ratios. We deal with performance ratios in this section, and with the other ratios in Section 3. The full list of performance ratios which we shall define and use in this section is set out below: Profitability Return on equity (%) Tax ratio (%) Return on net assets (%) Profit margin (%) Asset turnover Net asset turnover Fixed asset turnover Stock turnover Debtor turnover The first four ratios above relate to profitability, and the second four relate to sales divided by assets. These two kinds of measures are intended to help show how well a business is being run. The accounts of Precision Locks Limited for the year ended 30 June 2001 are set out on the right (together with comparative figures for 2000). You are asked to study the profit and loss account and balance sheet, and then to calculate the first four performance ratios listed. At each stage in the analysis you will be asked to calculate the appropriate ratios, and then to compare your answers with those set out on the pages immediately following. In each case the ratios for 2000 have already been calculated, and are set out alongside.
eBook - PDFCorporate Finance
Theory and Practice in Emerging Economies
- Sunil Mahajan(Author)
- 2020(Publication Date)
- Cambridge University Press(Publisher)
Short-term lenders prefer liquidity and, therefore, are keen to know the current ratio and the quick ratio. No single ratio or set of ratios can be appropriate for all occasions and purposes. The ratios we calculate and analyse should be appropriate for our objectives, be it performance evaluation, credit analysis or equity investment. Ratios are just numbers that tell us nothing by themselves. The interpretations of these numbers is critical and we must compare ratios across industries and over time in order to draw legitimate conclusions. Let us try and look at ratios differently, basing our analysis on the return on equity (ROE). It is a key parameter of performance. Given the risk profile of the company, managers try to maximize the return investors get on their equity investments. Let us see how different ratios dovetail into and capture the ROE. CHAPTER 13 300 | Corporate Finance Return on Equity (ROE) The ROE is defined as the net profit divided by the shareholders’ equity. ROE = net profit/shareholders’ equity. Which can be expanded as follows: ROE = (net profit/sales) * (sales/assets) * (assets/shareholders’ equity). Profit margin Asset turnover Financial Leverage Return on equity is thus determined by the following three parameters: 1. Profit margin: It is the difference between the sales price and the cost of the products. In a sense, this is the basic reason for the existence of the company; the fact that its products create value and thus are sold at a price that is higher than the cost. Every company tries to increase the margin on sales and, usually, the higher the profit margin, the better the performance. 2. Asset turnover: Investments of the company are in the form of long-term assets and net working capital. These assets are essential for running the business. The sales that can be generated from the invested capital determine the asset turnover. Higher the sales that can be generated with the assets, the better the performance.
eBook - PDF- Stephen L. Nelson(Author)
- 2021(Publication Date)
- For Dummies(Publisher)
In a sense, Profitability Ratios are the most important ratios that you can calculate. They typically provide terribly useful insights into how profitable a firm is and why. One particularly important Profitability Ratio is the gross margin percentage, which expresses gross margin as a percentage of sales. As discussed in Book 6, 374 BOOK 5 Financial Management Chapter 1, you can calculate a firm’s break-even point simply by dividing the firm’s fixed costs by its gross margin percentage. Gross margin percentage Also known as the gross profit margin ratio, the gross margin percentage shows how much a firm has left over after paying its COGS. The gross margin is what pays the operating expenses; financing expenses (interest); and, of course, the profits. The gross margin percentage ratio uses the following formula: gross margin/sales Using the data from Table 1-2 (shown earlier), you can calculate gross margin percentage as follows: $120,000/$150,000 This formula returns the value 0.8, meaning that gross margin equals 80 percent of the firm’s sales. No guideline exists for what a gross margin percentage should be. Some firms enjoy very high gross margins; other firms make good money even though the gross margin percentages are very low. In general, of course, the higher the gross margin percentage, the better. I need to make one cautionary statement here: In my humble opinion, small businesses should enjoy high gross margin percentages. I think it’s common to assume that a small business can get away with a lower gross margin percent -age than some large competitors can. In my experience, however, that isn’t true. Gross margin percentages should be higher for small businesses because small businesses often can’t get the economies of scale that large businesses can get. A low gross margin percentage may work fine for Walmart, for example, but it’s tough for a small retailer to work with such a small gross margin percentage.
eBook - PDF- Michael Broadbent, John M. Cullen(Authors)
- 2014(Publication Date)
- Butterworth-Heinemann(Publisher)
Knowing that a particular company has a Profitability Ratio of 16% is not useful in isolation. 2 Any ratio is only as accurate as the figures from which it was derived. The validity of comparing ratios from one period to another to establish trends will be affected by inflation, changes in account-ing policies adopted by the company and seasonal patterns for half-yearly reports. Assessment of company performance 49 Year 1 Year 2 £000 £000 Turnover 1,270 1,370 less Cost of sales 907 997 Operating profit 363 373 Fixed assets 2,574 4,574 Current assets 2,795 2,609 5,369 7,183 less Current liabilities 832 904 Capital employed 4,537 6,279 If two traditional ratios were calculated, one representing a profit-ability measure and the other an efficiency measure, the following would result: Year 1 Year 2 Operating profit/sales 28.5% 27.2% Return on capital employed Operating profit/capital employed 8.0% 5.9% Clearly performance in Year 2 is worse than Year 1. While sales have increased in monetary terms (from £1,270 to £1,370), if inflation were running at 10% then sales of £1,397 (£1,270 x 1.10) would have been required to keep pace. The cost of sales figure represents a 10% increase in cost from one year to the next, but overall profit-ability has declined. The return on capital employed figure of 5.9% in Year 2 represents a significant fall. While the profits have hardly changed, the capital employed has risen significantly, particularly the fixed asset figure. This may represent a major acquisition of fixed assets or the revalu-ation of the existing ones. In the former case the fall in return is quite serious as more assets are being used less efficiently, while the latter just represents a restatement of asset values, making year-by-year comparison invalid. 3 Inter-firm comparisons using accounting ratios will only be valid if the same accounting policies are adopted in preparing the accounts.
eBook - PDF- Timothy Mayes(Author)
- 2020(Publication Date)
- Cengage Learning EMEA(Publisher)
Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s). Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it. CHAPTER 3 Financial Statement Analysis Tools 106 firm is making use of its assets to generate sales; leverage ratios describe how much debt the firm is using to finance its assets; coverage ratios tell how much cash the firm has available to pay specific expenses; and Profitability Ratios measure how profitable the firm has been over a period of time. Aside from evaluating the level of the ratios, we described three ways that financial ratios can be used: (1) Trend analysis; (2) Comparisons to industry averages; and (3) Financial distress prediction. Each of these applications of ratios can be thought of as a puzzle piece that helps to complete the picture that describes the firm’s financial health. We have also seen how Excel can be programmed to do a rudimentary ratio analysis automatically, using only a few of the built-in logical functions. Finally, we looked at the concept of economic profit, which differs from net income in that it also considers the cost of equity capital, and how it can give a much clearer picture of a firm’s finan- cial health than traditional accounting profit measures. Table 3-1 provides a summary of the ratio formulas presented in this chapter.
eBook - PDF- Laurence Booth, Ian Rakita(Authors)
- 2020(Publication Date)
- Wiley(Publisher)
Efficiency ratios measure how efficiently a dollar of revenue is turned into profits, so we start with CP’s 2018 net profit margin of 26.7 percent, which is a very healthy figure. However, it is a measure of overall profitability and is frequently broken out into its major components. How this is done depends on the type of firm and the amount of data presented in its financial statements. Unfortunately, not all firms present a good breakdown of their cost structure on their income statements. When looking at a firm’s cost structure, economists like to think in terms of variable and fixed costs, where variable costs vary with the amount of production, and sales and fixed costs do not. Suppose a firm has revenues of $120 and variable costs of $72, or 60 percent of revenues. This means that the firm has a contribution margin of 40 percent, or $48 is available to contribute to the firm’s fixed costs and profits. With fixed operating costs of $31 and fixed interest costs of $5, the firm has taxable income of $12. With a 50-percent income tax rate, its net income and taxes are both $6, and the firm has a net profit margin of 5 percent. This example is illustrated in Table 4.4, which also shows what happens with a 10-percent increase and decrease in revenues. efficiency ratios ratios that measure how efficiently a dollar of revenue is turned into profits TABLE 4.3 Canadian Pacific, Canadian National, and U.S. Industry Average Leverage Ratios Canadian Pacific Canadian National U.S. Industry Average 2018 2017 2016 2018 2017 2016 2018 2017 2016 Leverage 3.2028 3.1280 4.1550 2.3363 2.2592 2.4969 2.7258 2.3126 2.8794 Debt ratio 0.6878 0.6803 0.7593 0.5720 0.5574 0.5995 0.6295 0.5668 0.6522 D/E ratio 1.3104 1.2675 1.8772 0.7125 0.6501 0.7369 0.9988 0.6953 0.8476 TIE 6.7130 6.2812 5.5690 12.6196 11.5800 11.2646 8.2871 8.2954 7.3217
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