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Profitability Ratios

The ability to generate profit on capital invested is a key determinant of a company's overall performance. Profitability reflects a company's competitive position in the market and the quality of its management. The income statement reveals the sources of earnings and the components of revenue and expenses. Earnings can be distributed to shareholders or reinvested in the company. Reinvested earnings enhance solvency and provide a cushion against short - term problems.

Calculation

Profitability ratios measure the return earned by the company during a period. The following table provides the details of the profitability ratios.

Return on sales profitability ratios expresses various subtotals on the income statement (gross profit, operating profit and net profit) as a percentage of revenue.

Return on investment profitability ratios measure income relative to assets, equity, or total capital employed by the company. For operating ROA, returns are measured as operating income. For ROA and ROE, returns are measured as net income. For return on common equity, returns are measured as net income minus preferred dividends as because preferred dividends are a return to preferred equity.

Profitability Ratios Numerator Denominator

Return on Sales

• Gross profit margin Gross profit Revenue
• Operating profit margin Operating income Revenue
• Pre-tax margin EBT Revenue
• Net profit margin Net income Revenue

Return on Investment

• Operating ROA Operating income Average total assets
• ROA Net income Average total assets
• Return on total capital EBIT Short & long term debt & equity
• ROE Net income Average total equity
• Return on common equity Net income Average common equity

-Preferred dividends

2.5.4.3 Interpretation

• Gross profit margin. Gross profit margin indicates the percentage of revenue available to cover operating and other expenditures. Higher gross profit margin indicates some combination of higher product pricing and lower product costs. The ability to charge a higher price is constrained by competition. If a product has a competitive advantage the company is better able to charge more for it. On the cost side, higher gross profit margin can also indicate that a company has a competitive advantage in product costs.
• Operating Profit margin: Operating profit is calculated as gross margin minus operating costs. So, an operating margin increasing faster than the gross margin can indicate improvements in controlling operating costs, such as administrative overheads. In contrast, a declining operating profit margin could be an indicator of decreasing control over operating costs.
• Pre-tax margin:Pre-tax income is calculated as operating profit minus interest, so this ratio reflects the effects on profitability of leverage and other (non operating) income and expenses.
• Net Profit margin: Net profit, or net income, is calculated as revenue minus all expenses. Net income includes both recurring and nonrecurring components. Generally, the net profit margin adjusted for nonrecurring items offers a better view of a company's potential future profitability.
• Return on Assets: ROA measures the return earned by a company on its assets. The higher the ratio, the better it is and it implies that more income is generated by a given level of assets.
• Return on total capital: Return on total capital measures the profits a company earns on all of the capital that it employs, including equity, long term and short term debt.
• Return on Equity: ROE measures the return earned by a company on its equity, including minority equity, preferred equity, and common equity. Return is measured as net. A variation of ROE is return on common equity, which measures the return earned by a company only on its common equity, wherein preference dividends are excluded from the net income and the preference shareholdings are excluded from calculating common shareholders.

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