# Profitability Ratios

Profitability ratios are financial ratios which measure a company’s ability to earn income. Important profitability ratios include gross profit margin, net profit margin, operating profit margin, return on assets, return on equity, return on capital employed and earnings per share, etc. Majority of the profitability ratios are income statement ratios.

Because companies are of different sizes in terms of their sales volumes, shareholders equity and asset base and because their sales, equity and asset base change over time, it is important to standardize financial performance of companies by calculating the relationship between the most common financial indicators. This standardization is carried out by calculating financial ratios which help us compare different aspects of a company’s financial performance and financial position i.e. solvency, liquidity, efficiency, etc. with other companies and between different periods for the same company. Profitability ratios are financial ratios which standardize a company’s income generation.

There are two categories of profitability ratios: (a) return on sales ratios and (b) return on investment ratios. There are a number of return on sales depending on the definition of income being used (i.e. gross profit vs operating income vs EBIT, etc.) which calculate dollars of relevant income per 100 dollars of net revenue. The return on investment ratios include an income statement item in numerators and a balance sheet item in the denominator and determine dollars earned per 100 dollars of investment in equity or assets.

The following table summarizes the most common profitability ratios along with their formulas:

Ratio Numerator Denominator Where
Gross profit margin Gross profit Net revenue Gross profit equals net revenue minus cost of sales
Operating margin Operating Income Net revenue Operating income equals income from operating activities.
EBIT margin EBIT Net revenue EBIT stands for earnings before interest and taxes
Pretax margin EBT Net revenue EBT stands for earnings before taxes
Net profit margin Net income Net revenue
Earnings per share Net income attributable to common stockholders Weighted average number of shares of common stock Net income attributable to common stockholders equals net income minus preferred dividends
Diluted EPS Net income attributable to common stock-holders Weighted average number of shares including dilutive securities Weighted average number of shares that would exist if all dilutive convertible securities are converted to common stock
Return on assets (ROA) Net income or operating income Average assets Average assets = (beginning balance of assets + closing balance of assets)/2
Return on equity (ROE) Net income Average shareholders equity Average shareholders equity equals the sum of opening and closing balances of shareholders equity divided by 2.
Return on capital employed (ROCE) EBIT Total capital employed Total capital employed equals total shareholders equity plus sum of interest-bearing debt.

Gross profit margin is the most high-level profitability ratio which calculates the percentage of net revenue that is left over after subtraction of cost of sales. Cost of sales represents the direct cost of revenue including materials, direct labor and manufacturing overheads.

Operating margin and EBIT margin are similar in the sense that both measure income before interest and taxes. However, operating margin also excludes any income or expense which is not of operating nature, but EBIT doesn’t. For example, investment income will be included in EBIT margin but excluded from operating margin.

Net profit margin is arguably the most common income statement ratio. It measures the percentage of net revenue that is ultimately available after all netting off all expenses. Pretax margin calculates the percentage of earnings before taxes with reference to net revenue. Pretax margin equals net profit margin multiplied by (1 – tax rate).

EPS stands for earning per share. There are two variants of the ratio: the basic EPS and diluted EPS. EPS is such an important ratio that separate accounting standards exists to stipulate how to calculate it.

Return on assets (ROA) is calculated either with net income or operating income in the numerator and average assets in the denominator. It calculates dollars earned per 100 dollars of average assets.

Return on equity (ROE) calculates dollars of net income per 100 dollars of average shareholders equity. A high ROE means that the company is generating more money for investors per 100 dollars of their money.

ROE can be converted to ROA using the following formula:

$$\text{ROE}=\frac{\text{NI}}{\text{E}}\times\frac{\text{A}}{\text{A}}=\frac{\text{NI}}{\text{A}}\times\frac{\text{A}}{\text{E}}=\text{ROA}\times \text{Equity Multiplier}$$

ROE can be further decomposed using the DuPont analysis into net profit margin, asset turnover ratio and equity multiplier (also called financial leverage ratio).

$$\text{ROE}=\text{Net Profit Margin}\times \text{Asset Turnover Ratio}\times \text{Equity Multiplier}$$

Return on capital employed compares a company’s EBIT with average capital employed where capital employed equals total shareholders equity plus interest-bearing short-term and long-term debt. Return on capital employed is also called return on total capital. EBIT is used in the denominator because the denominator includes both debt and equity.