How to Use Profitability Ratios
Different Types of Calculations that Determine a Firm's Profits
Learn to use profitability ratios for your business. Here is how they are calculated and what they represent.
Profitability analysis is vital for your business - you are able to conduct a simple analysis by applying profitability ratios. Here are four types of profitability ratios. Learn how they are calculated and what they indicate for your business' financial performance.
Profitability Margins
Firstly, a gross profit ratio indicates the amount you are making over sales. Sales or revenue does not necessarily indicate that your business if profitable. Your costs may be eating away at your profit margin. The calculation of the profit margin is by dividing (sales - cost of goods sold (cogs)) by sales.
This profit ratio indicates the total margin available to cover operating expenses and yield a profit.
For a more concise analysis, you could minus out interest and tax from your profit (which is essentially sales - cogs). This would give you a more specific indication of your net profit margin. The formula would now look like this: (sales - cogs - (interest + tax)) / sales.
This profit ratio indicates the net profit margin available to cover operating expenses and yield a profit.
Returns on Assets Margins
A return on assets calculation denotes the return on investment. Assets are made out of debtors (shareholders) and creditors. It is therefore wise to analyse the profitability of an asset with respect to the revenue it is able to yield.
The margin can therefore be calculated as gross profits (before interest and tax) or net profits (after interest and tax) divided by total assets.
These margins provide an indication of the productivity of assets - the amount of revenue that one unit of asset is able to generate.
Returns on Capital Margins
It is also important to calculate shareholders' earnings. By narrowing down assets to just looking at capital, you will be able to distinguish your rate of return on shareholder investment.
The calculation is also simple. It can be calculated as gross profits or net profits over shareholder equity. This margin indicates the returns that are available to owners of the company.
Shareholdings are made out of preferred and common shares. It is more common to calculate ratios based on common shares as common shares are more or less fixed whereas preferred shares are usually injected to finance specific projects.
Therefore to calculate returns on common shares, use the formula that looks like this: (net profit - preferred stock dividend) / common stock.
To break it down further, you are able to calculate earnings per share by dividing (net profits - preferred stock dividend) by number of common stock outstanding.
