Profitability Ratios Explained: Types of Profitability Ratios

Profitability ratios are measurements of a company's ability to earn profits in relation to other metrics, such as total revenue, assets, the profitability of competing companies, the company's past performance, and other factors. These financial ratios indicate how well the company has generated value, cash flow, and profit over a specific period of time. In general, the higher the profitability ratio, the more favorable the company's financial health and outlook.

Profitability ratios are significant because they allow stakeholders to see a company's performance with some precision. This financial analysis information can be of special value in certain circumstances:

• Attracting investors: Investors understandably want to see that a business has the capacity to be profitable before they make any investments. Profitability ratios provide the data investors need to make sound investment decisions.
• Assessing seasonal businesses: Businesses whose net sales revenue varies greatly from one season to the next (such as retailers who make most of their income during the year-end holidays or recreational equipment companies who rely on summertime sales) can benefit from using profitability ratios. By comparing historical performance and the company's earnings across the same quarters over several years, management has a clear measure of profitability that helps them make smart budgeting and strategic planning decisions.
• Revealing problematic sectors of a company: Financial statements, including balance sheets and income statements, can only reveal the big picture about a business. Assessments that include profitability ratios allow analysts to investigate various areas of the business to spot specific problems, such as a rising cost of goods sold.
• Comparing a company to competitors: If competitors are more established than a small business, a comparison of revenue may not be revelatory or helpful. However, a comparison of profitability ratios lets small business owners know how they measure up in terms of efficiency and profit, which is helpful.

The most useful types of profitability ratios can be categorized in three ways:

1. 1. Margin ratios: Margin ratios give insight, from several different angles, on a company's ability to turn total sales into profits.
2. 2. Return ratios: Return ratios, which are calculated using data from a company's profit and loss statement and balance sheet, provide information about how well the business generates returns. This ratio measures how well the company converts assets, equity, and debt into return on investment.
3. 3. Cash flow ratios: Cash flow ratios move beyond the bottom line to help businesses understand whether they're running a cash surplus or deficit. They're particularly important because a lack of cash can cause even a profitable business to fail.

Among the key margin ratios that provide useful data are:

1. 1. Gross profit margin ratio: Measures a company's net income after subtracting the cost of goods sold (COGS).
2. 2. Net profit margin ratio: Measures income and earnings after all expenses and taxes have been deducted.
3. 3. Operating profit margin: Measures sales income after subtracting operating expenses and COGS.
4. 4. Pretax margin: Measures company profits after subtracting operating costs, non-operating expenses, and COGS.
5. 5. EBITDA margin: Measures earnings before interest, income tax and other taxes, depreciation, and amortization (EBITDA); some companies also measure EBIT (earnings before interest and tax).

The most common return ratios are:

1. 1. Return on equity (ROE): Shows how well a company uses investments to generate profits. Calculated as net profits divided by investors' or shareholders' equity, this equity ratio helps to evaluate the efficacy of a company's financial management.
2. 2. Return on assets (ROA): Shows how well a company uses its total assets to generate profits and can be increased through economies of scale. This asset ratio is particularly useful for companies in sectors that require significant investment in assets, such as the telecommunications or manufacturing sectors.
3. 3. Return on capital employed (ROCE): Indicates how well a company uses its capital resources, including retained earnings, share capital, and long-term debt.

The two most useful cash flow ratios are:

• Cash flow margin ratio: Measures cash movement across a given period by adding changes in working capital and non-cash entries back into the company's net profits.
• Net cash flow ratio: Measures whether a company is running a cash surplus or deficit to determine whether it needs additional financing.

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