Definition
A profitability ratio is a measure of profitability, which is a way to measure a company's performance. Profitability is simply the capacity to make a profit, and a profit is what is left over from income earned after you have deducted all costs and expenses related to earning the income. The formulas you are about to learn can be used to judge a company's performance and to compare its performance against other similarly situated companies.Types of Profitability Ratios
Common profitability ratios used in analyzing a company's performance include gross profit margin (GPM), operating margin (OM), return on assets (ROA) , return on equity (ROE), return on sales (ROS), and return on investment (ROI). Let's take a look at these in some detail.Gross Margin
Gross margin tells you about the profitability of your goods and services. It tells you how much it costs you to produce the product. It is calculated by dividing your gross profit (GP) by your net sales (NS) and multiplying the quotient by 100:Gross Margin = Gross Profit/Net Sales x 100
or
GM = GP/NS x 100
Example: Imagine that you run a company that sold $50,000,000 in running shoes last year and had a gross profit of $7,000,000. What was your company's gross margin for the year?
GM = GP/NS x 100
GM = $7,000,000/$50,000,000 x 100
GM = .14 x 100
GM = 14%
For every dollar in shoe sales, you earned 14 cents in profit, but spent 86 cents to make it.
Operating Margin
Operating margin takes into account the costs of producing the product or services that are unrelated to the direct production of the product or services, such as overhead and administrative expenses. It is calculated by dividing your operating profit (OP) by your net sales (NS) and multiplying the quotient by 100:Operating Margin = Operating Profit/Net Sales x 100
or
OM = OP/NS x 100
Example: Let's say you make and sell computers. Last year you generated net sales of $12,000,000 and your operating income was $100,000,000. What was your operating margin?
OM = OI/NS x 100
OM = $12,000,000/$100,000,000 x100
OM = 0.12 x 100
OM = 12%
Out of every dollar you made in sales, you spent twelve cents in expenses unrelated to the direct production of the computers.
Return on Assets
This metric measures how effectively the company produces income from its assets. You calculate it by dividing net income (NI) for the current year by the value of all the company's assets (A) and multiplying the quotient by 100:Return on Assets = Net Income/Assets x 100
or
ROA = NI/A x 100
Example: Imagine that you are the president of a large company that manufactures steel. Last year you company had net income of $25,000,000, and the total value of its assets such as plant, equipment, and machinery totaled $135,000,000. What was your return on assets last year?
ROA = $25,000,000/$135,000,000 x 100
ROA = 0.185 x 100
ROA = 18.5%
This means that you generate 18.5 cents of income for every dollar your company holds in assets.
Return on Equity
Return on equity measures how much a company makes for each dollar that investors put into it. You calculate it by taking the net income earned (NI) by the amount of money invested by shareholders (SI) and multiplying the quotient by 100:Return on Equity = Net Income/Shareholder Investment x 100
or
ROE = NI/SI x 100
Example: Imagine that your social media company just went public last year resulting in a total investment of $100,000,000. Your company's net income for the year the year was $10,000,000. What is the return on equity?
ROE = NI/SI x100
ROE = $10,000,000/100,000,000 x 100
ROE = 0.10 x 100
ROE = 10%
Your company is generating a dime in profit for every dollar invested.