Profitability Ratios Measure Margins and Returns
Profit Ratios Work with Gross, Operating, Pretax and Net Profits
Apr 4, 2009
Published financial statements of companies disclose profits at different stages. Profitability ratios focus on these, and constitute just one category of financial ratios. In the next section we look at profits and profitability ratios. We will look at other financial ratios in separate articles.
Gross, Operating, Pretax and Net Profits
- Gross profit is the surplus generated by sales over cost of goods sold. Cost of goods sold includes direct costs such as materials/merchandise costs, carriage inwards on these, processing costs and production overhead. Efficient materials procurement & handling, and well-designed and executed production processes keep costs low and increase the gross margin.
- Operating profits are arrived at by deducting marketing, administration, depreciation and R&D costs from the gross margin. Companies seek to maximize operating costs through efficient operations and effective marketing.
- Pretax profits are computed by deducting non-operational expenses from operating profits and by adding non-operational revenues to it. It thus accounts for incidental income and expenditure in addition to items related to regular operations.
- Net profits are the profits that remain after tax. Tax burden can be minimized through legal tax avoidance measures. It is this final profit that is available for distribution as dividend or for adding to shareholder equity as retained earnings.
Profit Margin Ratios
Profit margin ratios compare the four levels of profits mentioned in the previous section with the net sales or revenue amount. The ratios are typically converted into percentages for easy understanding.
- Gross Profit Margin = Gross Profit/Net Sales or Revenue
- Operating Profit Margin = Operating Profit/Net Sales or Revenue
- Pretax Profit Margin = Pretax Profit/Net Sales or Revenue
- Net Profit Margin = Net Profit/Net Sales or Revenue
There are no universal profit margins applicable to all businesses. Instead, the margins tend to vary from industry to industry and product line to product line. The value of profitability ratio analysis lies in:
- The ease with which historical performance can be compared. Thus, it is possible to compare this year's gross profit margin with last year's, and analyze the reasons for any variation. The findings from the analysis are likely to provide high value insights.
- The opportunity to compare the performance of different companies engaged in the same business. This peer comparison can provide an indication of how well a company is doing as against its competitors.
- Similarly, comparison can also be made against industry averages, though this can be less meaningful if the industry accommodates players with very different product lines.
Returns on Resources Used
- ROA ratio: Return on Assets = Net Profit/((Total Assets at beginning of the period + Total Assets at the close of the period)/2) - The denominator is the average total assets employed during the year.
- ROE ratio: Return on Equity = Net Profit/((Shareholders' Equity at the beginning of the year + Shareholders' Equity at the close of the year)/2)
- ROCE ratio: Return on Capital Employed = Net Profit/(Average Shareholders' Equity + Average Debt Liabilities) - Debt Liabilities mean interest bearing long-term and short-term borrowings. Both debt and equity are averaged by dividing the total of opening and closing amounts by two.
ROA ratio can be low for a capital intensive heavy industry and high for low capital service industry. Hence it is used best for historical comparison of performance from year to year, or for comparing peer companies making the same line of products.
ROE is of primary interest to investors who want to know how much returns they can expect on the shares they purchase. ROE alone might not provide the full picture. A high ROE can be obtained by borrowing heavily and using the borrowed funds to create substantial facilities. However, the returns could disappear if the company finds itself unable to service the borrowings during a slowdown in business, even if temporary.
ROCE is a better measure of the company's ability to earn returns on the funds it employs than ROE, which can be distorted by high 'gearing', i.e. high borrowings and low shareholder funds.
Profitability ratios measure both the profit margins that the company is able to generate as well as the returns it provides on the physical facilities and funds it employs. Return ratios are net profit ratios, while margin ratios compare gross profit, operating profit, pretax profit and net profit to revenue.
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