When you begin analyzing stocks to determine which would be a better investment, profitability ratios can give a good indication of a company’s overall health.
Profitability ratios show a company’s ability to produce profit and value for shareholders and its ability to reinvest in growth for future profit.
What is the best measure of profitability?
Net profit margin, or the ratio of profits to total revenues, is a key indicator of a company’s financial strength. It shows how much of the company’s total earnings — minus operating and other expenses — are retained. A higher net profit margin is typically a sign the company is financially sound, but the ratio should be stacked against competing businesses as numbers can vary among industries.
Net profit is also a value that is more easily subject to accounting manipulation, so looking at the historical averages of a company vs. a single quarter snapshot will give a better picture of a business’s profitability.
How do you interpret profitability ratios?
Typically, it is best to have a higher ratio, but be sure to compare the ratios to other companies within the same sector or with a company’s own financial history to get an accurate picture of a firm’s performance.
Here are some ratios to consider when looking at profitability:
- Gross profit ratio is used to look at how efficiently a company turns inputs into sellable goods and services. It is found by examining gross profit and net sales revenue.
Calculating gross profit. Gross profit is calculated by subtracting the cost of goods sold from net sales. The cost of goods sold includes the cost to produce a product, such as materials, labor and storage. The gross profit ratio is found by dividing the gross profit by net sales.
The gross profit is often calculated into gross profit margin — a percentage found by dividing gross profit by revenue. A higher gross profit margin shows a company is making more profit on sales. The higher a company’s gross profit margin, the more room the company has to fund its operating expenses. Companies with low gross profit margins, like grocery stores, have to operate extremely efficiently in order to remain profitable overall.
Profit margins vary by industry. A company’s income statement usually will have the information needed to find the ratio.
- Operating profit margins show the company’s ability to convert sales into pre-tax and pre-interest on debt profits. Operating profit is also known as a company’s earnings before interest and taxes (EBIT) profit. This is one of the best ways to look at a business’s all-in profitability, because it includes both cost of goods and operating expenses, but excludes many of the one-off and otherwise more discretionary line items that get you to Net Income.
Calculating operating profit margins. Operating profit is found by deducting operating expenses, such as administrative costs, from gross profits. The number will show the percentage of revenue retained by the business after costs. The profit margin is calculated by taking the operating profit divided by net sales or revenue.
- DuPont return on equity (ROE) is a model used to find what causes the Return on Equity. Return on Equity is a firm’s profitability after debt holders are paid relative to the amount of equity in the firm, and thus it indicates a company’s ability to generate returns for shareholders. The DuPont model helps see different sub-components of ROE to analyze where the returns are coming from.
Calculating ROE. This is simply Net Income divided by Total Shareholder’s Equity.
- Cash return on invested capital (CROIC). This shows how a business generates cash returns on its investments. It looks at how much free cash flow a business generates annually compared to the total amount of capital that is invested into the business.
Calculating CROIC. CROIC is Free Cash Flow (FCF) divided by Invested Capital. Free Cash Flow can be most simply calculated by subtracting Capital Expenditures from Cash From Operations on the Cash Flow Statement. Invested Capital is the sum of the book value of equity, total debt (including capital leases, notes payable, and any other debt-like instrument on the balance sheet), and minority interests, minus cash and equivalents.
- Free cash flow to sales (FCF/S) is another way to look at operating profitability. As helpful as EBIT is as a measure of a business’s performance, the free cash flow a company can generate is the true measure of its performance. Measuring the percent of sales that turns into cash reveals how much is left over for owners of the business after everything is taken into account.
Profitability ratios can tell you if a company is earning a profit and adding value for shareholders. Analyzing these ratios helps potential investors identify how the business is operating, how efficiently it generates a profit and which areas of the business need to be refined.