Profitability Ratios evaluate the financial viability of a business and provide a measure of comparison and performance to the industry in which the business falls.
These ratios include:
NET MARGIN RATIO
The Net Margin Ratio measures how much a company earns after taxes relative to its sales. The formula is as follows:
Net Profit Margin = Net Profit/Revenue
A higher net profit margin tells the investor the business is more efficient and flexible and capable of taking on new opportunities.
OPERATING PROFIT MARGIN RATIO
The Operating Profit Margin Ratio measures earnings before interest and taxes (EBIT). The formula is as follows:
Operating Profit Margin = Operating Income/Net Sales
This gives the investor an idea of whether they want to invest in a company and bankers an idea of whether they should consider providing additional debt financing.
RETURN ON ASSETS RATIO
The Return on Assets Ratio measures how well management is using the company’s resources. The formula is as follows:
Return on Assets = Net Income/Total Assets
This will vary widely by industry but it gives investors an idea of how well the company is leveraging its assets to benefit the investment return.
RETURN ON EQUITY RATIO
The Return on Equity Ratio measures how well the business as an investment is doing relative to the investment by its shareholders. The formula is as follows:
Return on Equity = Net Income/Shareholder’s Equity
This helps investors understand how much money the company is earning for each invested dollar and may be a good predictor of return for their investment.
If you would like to learn more about Financial Ratios and how they may be used, read the post, Financial Ratio Analysis and the Entrepreneur.
Rogers, S. (2014). Entrepreneurial Finance: Finance and Business Strategies for the Serious Entrepreneur. New York: McGraw Hill Education.