What Are Profitability Ratios?
Companies today produce a tremendous amount of revenue, and consequently expenses. Profitability ratios express these numbers in a simple and easily comparable format.
Profitability ratios measure a company’s ability to produce income relative to its expenses. Since each company has different market capitalization and capital structures, these ratios make it easy to compare companies side by side. These ratios are relevant over time periods, typically quarters or years.
Furthermore, these ratios show how well a company utilizes its assets to generate income and create shareholder value. Various types of profitability ratios exits, each measures efficiency in a different area. Some that focus on earnings are: operating margin and gross margin. Also, others that measure balance sheet performance are return on assets (ROA), return on equity (ROE) and return on capital (ROC).
Evaluating Profitability Ratios
As shown above, profitability ratios focus on margin and return. Gross margin shows the cost of goods sold (COGS) as a percentage of sales. This shows how much it costs a company to produce the goods it sells. Investors keep an extremely close eye on this measure as an upward trend shows investment opportunity to create even more value. Operating margin shows how efficiently a company conducts its core business relative to its sales. Core business operation expenses include necessary items such as wages, rent and insurance.
Additionally, return ratios such as ROE show how investors earn return on their investment. If a company increases its asset base without taking on large debt, shareholders experience higher returns. This is a classic example of organic growth. Also, ROA shows how efficiently a company’s asset base translates to sales. The theory holds that economies of scale generally lower production cost. Thus higher ROA shows the potential for future growth, which attracts investors.
Profitability ratios help investors and analysts compare companies within similar industries. Evaluating trends over time relative to stock prices reveal profitable investment opportunities, and raise red flags on lagging companies.