Financial Ratios – Profitability Ratios

Profitability ratios can be classified into two categories. 

1.    Profit margin ratios
2.    Rate of return ratios

Profit margin ratios show the relation between the profit and the sales whereas the rate of return ratios show the relation between profit and the investment.

Profit margin Ratios

Profit margin is referred to the relation between the earnings of a company and its sales. If a company has higher profit margin that company is more efficient. Usually in less competitive market (sector) the companies enjoy high profit margins.

Gross profit margin      = Gross profit / Sales

Gross profit is the difference between net sales and cost of goods sold. This ratio shows the margin left after covering manufacturing cost.  This profit is before overhead, payroll, interest and tax.

Operating profit margin = EBIT / Sales

EBIT is Earnings Before Interest and Tax.

Net profit margin =  Net profit / Sales

Net profit is the bottom line of a company i.e. it’s the profit after deducting all sorts of expenses, taxes, depreciation etc.

Rate of return Ratios

Return on Assets = Net Income / Total Assets

Please note that the numerator is net income not the net profit.  It shows how efficiently the capital is employed.

Return on investment (ROI) = EBIT / Total assets

EBIT is Earnings Before Interest and Tax.

Since this ratio is not affected by interest and taxes it measures business performance. Let’s say if a company’s net profit is negative but its ROI is good then it’s good have in our portfolio for long term. This is because the negative net profit may be because of the high cost debt; but since the business performance is good it will give positive net profit as soon as the debt is paid out.

Return on Equity (ROE) =  Equity Earnings / Net worth

Equity earnings are the profit after tax (less preferential dividend). Net worth is the share holders’ fund, reserves and surplus.
 

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May 31, 2009 | Filed Under Fundamental Analysis 

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