The Value of Profitability Ratios
Profitability ratios measure how well a company uses assets to generate profit. They can be based on sales, assets or equity. The higher the ratio the more profitable to the company. Ratios may include gross profit margin, operating margin, net margin, return on assets, and return on equity.
Gross Profit Margin
Gross profit margin is a profitability ratio that measures the amount a company earns above the cost of goods sold. This ratio tells how well a company creates its services or products compared to competitors. It also shows how efficient it uses materials and labor to produce and sell products. Cost of goods sold (COGS) is direct costs such as raw materials and direct labor. The formula for gross profit margin is:
Gross Profit Margin = (Total Sales – Cost of Goods Sold) / Sales
This ratio is important to management and investors as it shows how profitable core business activities are excluding indirect costs. In other words, it shows how profitable a product is. Adequate gross margins enable a company to pay operating expenses.
Your pricing strategy often drives the gross margin. Selling products at a premium in the market results in a higher gross margin. However, if the price is too high, fewer customers may buy it.
Operating margin (also known as return on sales) is the profit remaining after deducting selling, general and administrative costs (SG&A). SG&A costs may include employee salaries, utilities, advertising, and rent to name a few. The formula for operating margin is:
Operating Margin = Operating Profit / Sales
This ratio measure how much profit a company makes on each dollar of sales. This formula uses operating profit which is profit after variable costs like wages and raw materials but before interest or taxes. An adequate operating margin leaves a proportion of revenue available to cover non-operating costs like interest and tax expenses.
Creditors and investors look at this ratio to see how strong and profitable a company’s operations are. A high operating margin is more favorable as it shows a company is making enough money to pay both variable and fixed costs. By analyzing past margins, one can see whether earnings are improving and sustainable long-term.
Net margin is the percentage remaining after all expenses have been paid. This includes taxes and financing costs, such as interest expense. This ratio tells you what percentage of each dollar in revenue turns into profit. It is also known as “profit margin” or “net profit margin ratio”. The formula for net margin is:
Net Margin = Net Income / Sales
Net profit margin is one of the most important indicators of a company’s financial health. Because net profit margin is a percentage rather than a dollar amount, it is easy to compare the profitability of various companies regardless of the size. Tracking increases and decreases to net profit margin shows whether current operations are efficient and profitable.
Creditors and investors can assess if a company is generating enough profit from sales and that operating and overhead costs are not excessive. For instance, a company may have growing revenue, but if its operating costs are increasing at a faster rate than revenue, its net profit margin will shrink. Ideally, creditors and investors want to see a track record of growing margins.
A high net profit margin means a company is effectively controlling costs and/or providing goods or services at a price greater than its costs. While a low net profit margin may mean an ineffective cost structure and/or poor pricing strategies. At the end of the day, higher margins means more sales turning into profit which can then be dispersed to shareholders. Keep in mind some industries may have lower average margins, but may still be profitable because of the sheer volume of sales.
Return on Assets
Return on assets (ROA) measures the profitability of a company in relation to its total assets. It compares the profit it is generating to its investments in assets. The higher the return, the more productive and efficient a company is at utilizing resources. Hence, the company is earning more money on less investment. The formula for ROA is:
Return on Assets = Net Income / Total Assets
ROA gives a creditor or investor an idea of how efficient a company is at using assets to generate earnings. This ratio is a return on investment for the company as capital assets are often the biggest investment for many companies. In short, it measures how profitable these assets are. It is useful to use average assets as they grow or shrink over a period.
ROA varies from industry to industry. So, it is important to compare a company’s performance to previous periods or to similar size companies in the industry. For instance, construction companies have a high investment in capital assets while software companies have less.
Return on Equity
Return on equity (ROE) measures how profitable the company is for its shareholders.This ratio is a key indicator of how efficiently a company is using equity financing to fund operations and grow the company. The formula for ROE is:
Return on Equity = Net Income / Total Equity
Unlike the other profitability ratios, ROE is from the investor’s point of view – not the company’s. This ratio calculates how much money an investor makes on their investment in the company, not the company’s investment in assets. As such, investors want to see a high return on equity ratio because it shows how effectively the company is using the investors’ funds to generate net income.
Return on equity whether good or bad is dependent on what is normal for peer companies. A ratio of 1 means that every dollar of equity generates 1 dollar of net income. A good rule of thumb is to have a target ROE that is equal to or above average for your peer group.
Ratios in Use
Ultimately, the higher your profitability ratios the more successful your business. Once you learn about each of these ratios, you can compare them to industry averages and previous time periods. This provides insight and value to your analysis and understanding of your business. You can then identify trends, develop strategic goals, and make changes to grow your business.
We at Peak Business Valuation would love to help you understand your financial analysis and how to use it to grow. We are happy to answer any questions you have. Please reach out via email or phone call.Schedule Your Free Consultation Today!