Introduction to Measures of Profitability

What you will learn to do: Calculate ratios that analyze a company’s earnings performance

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Profitability ratios are a class of financial metrics used to assess a business’s ability to generate earnings relative to its revenue, operating costs, balance sheet assets, or shareholders’ equity over time, using data from a specific point in time.

Profitability ratios are one of the most popular metrics used in financial analysis, and they generally fall into two categories—return ratios and margin ratios.

Return ratios offer several different ways to examine how well a company generates a return for its shareholders and include return on assets (ROA) and return on equity (ROE).

Margin ratios give insight, from several different angles, on a company’s ability to turn sales into a profit. For instance, gross margin measures how much a company makes after accounting for COGS. The net profit margin is a company’s ability to generate earnings after all expenses and taxes.

Other ratios that measure profitability (the ability to make a profit) that will be covered in this section include:

  • Earnings per share
  • Price-earnings ratio
  • Dividend payout ratio
  • Free cash flow

In addition, once you get the hang of margin ratios, you could calculate margins on operating income, pre-tax income, or any other point on the income statement relative to sales or some other base, depending on what you are trying to analyze.

For most profitability ratios, having a higher value relative to a competitor’s ratio or relative to the same ratio from a previous period indicates that the company is doing well. Profitability ratios are most useful when compared to similar companies, the company’s own history, or average ratios for the company’s industry.