Know Your Profitability Ratios

A profitability ratio is a measure of how successfully a company turns its underlying financial performance into profit. Profitability ratios can indicate whether a company is out-pacing a competitor, its performance from last year or its performance from last quarter. A profitability ratio can also provide insight into how aggressively a company is looking to grow its operations and move forward. As an investor, looking at key profitability ratios will help you understand how much you can expect to earn from dividends and capital gains on a stock.

Profit Margin

Profit margin measures how much of its earnings a company gets to keep as profit at the end of a financial cycle. It can be calculated using the formula:

  • net income divided by revenue
  • Net income accounts for only the dollars a company actually keeps in the bank after it has finished paying out expenses, interest on debts and taxes.
  • Revenue is the sum of all the sales the company made in a year.

The higher a company's profit margin, the more it is leveraging the money it spends to make a profit. A low profit margin indicates a company is spending a lot of money and making just a little money.

Return on Assets

A company's return on assets shows how well it is leveraging the assets it holds to generate profit. For example, a company with $3 million worth of technical equipment should generate a higher profit than a company with $300,000 of technical equipment. Even if its profit is higher, the company should also want to have a profit that is proportionally higher. This means it not only earns more than the company with a smaller asset base, it earns more in comparison to its assets. Return on assets can be calculated with the formula:

  • net income divided by total assets. 

Return on Equity

Return on equity (ROE) may seem like return on assets, but evaluates a different metric. Equity accounts are analytical tools that are used for the financial portfolio that makes up its capital base. For example, if a company takes on a lot of new shareholders in a given year, it receives a boost of equity. This boost should coincide with a proportional boost in profit. If the company's profit is small, compared to what the investors took on, the investors will have to divvy up the profit into much smaller dividends. 

Profitability Shortfalls

These types of measurements tend to be inexact measuring tools. There are a number of factors that can throw off probability and provide an indicator that is not accurate. For example, seasonal profitability plagues industries such as construction and retail. On a similar note, some industries have very high barriers to entry, i.e., they cost more than other industries. As a result, an investor needs to understand the industry and its standard profitability to truly understand whether an individual company is performing well.

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