Profitability Ratios

Profitability ratios measure how profitable a company is. 

Gross Profit Margin

Gross profit margin measures gross profit as a percentage of gross revenue. This helps capture profit as a percentage of revenue, and helps assess components that affect profitability.

Net Profit Margin

When net profit or the bottom line, profit after subtracting all costs is shown as a percentage of gross sales we call it net profit margin.

This margin varies from industry to industry. For example a 5-6% profit in the steel manufacturing industry is considered very good, but poor for the pharmaceutical industry. It also needs to be compared with the firm’s historical performance.

Cost per Sales Dollar

This helps estimate sales and marketing as a percentage of Gross Sales. This helps in cost control.

We will now look at the profitability ratios that look at profits relative to the funds invested in the business (Return on Investment).

Return on Assets

This measure calculates the returns as a percentage of total assets. It uses net income as the numerator. This ratio tells us how much returns the company generated from the invested capital.

One problem with this measure is that the denominator (total assets) contains both debt and equity. However, the numerator (net income) excludes interest. For this reason, sometimes the denominator is adjusted by adding back the interest expense net of taxes.

Operating Return on Assets (ROA)

Operating ROA is calculated just like Return on Assets but uses Earnings Before Interest and Taxes (EBIT) instead on Net Income.