PROFITABILITY RATIOS:

The fourth classification of ratios are known as profitability ratios. Profitability Ratios are of great importance to investors since they measure how effectively management is generating profits from corporate assets and from owner's investments. The most common profitability ratios include; gross profit margin ratio, net profit margin ratio, return on total assets ratio, and the return on equity ratio. Let's explain each separately, beginning with the Gross Profit Margin.

GROSS PROFIT MARGIN:

The gross profit margin provides an indication of how well a company is setting its product's prices and controlling its production costs. Here's how the gross profit margin is calculated;

As you can see, two items are required before a company can calculate its gross profit margin; Sales and Cost of Goods Sold. As indicated earlier, sales represent a company's total receipts from selling its products or services to customers. In other words, when a company sells products or services to its customers, the company is said to be making sales. Cost of Goods Sold, as the name implies, represents the costs incurred on all products sold. Furthermore, a business can only recognize, as an expense, the costs of the products it sells. Unsold products are still owned by a business and considered inventory.

The "Sales" account and the "Cost of Goods Sold" account both appear on a company's income statement. The Widget Manufacturing Company's income statement section needed for calculating its gross profit margin is presented below.

Using the above figures, we can calculate the Widget Company's Gross Profit Margin as of December 31, 200Y.

As you can see, the company's gross profit margin is 0.24 . This means, $0.24 cents is made from every one dollar ($1.00) generated in sales. In other words, a cost of $0.76 ($1.00-$0.24) is incurred by the company for every $1.00 it takes in from sales. Let's drive the point home by saying;

For every one dollar generated by the company, $0.76 cents is used to pay for the products it sells and the other $0.24 cents remains in the company to pay for its operating expenses, income taxes, dividends, etc...

Note: the higher the gross profit margin, the more stable a company is considered. Moreover, a higher gross profit margin indicates the company is making more from each sale. On the other hand, the lower a company's gross profit margin, the less money it makes from each sale, and therefore the less stable the company appears. The next profitability ratio is called the Net Profit Margin.

NET PROFIT MARGIN

The Net Profit Margin ratio shows a company's after tax profit per dollar of sales. Sub-par profit margins indicate the firm's selling prices are relatively low or that its expenses are relatively high, or both. Here's how the net profit margin is calculated;

As you can see, two items are required before a company can calculate its net profit margin; Sales and Net Income After Taxes. As indicated earlier, sales represent the company's total receipts from selling its products or services to customers. In other words, when a company sells products or services to its customers, the company is said to be generating sales. Net Income After Taxes is calculated by subtracting a company's cost of goods sold, operating expenses, and tax obligations from its revenues (Sales).

The sales account and the net income after taxes account both appear on a company's income statement. The Widget Manufacturing Company's income statement section, needed for calculating the net profit margin, is presented below.

Using the above figures, we can calculate the Widget Company's Net Profit Margin as of December 31, 200Y.

As you can see, the company's gross profit margin is 0.04 . This means, $0.04 cents is made from every one dollar ($1.00) generated in sales. In other words, a cost of $0.96 ($1.00-$0.04) is incurred by the company for every $1.00 it takes in from sales. Let's drive the point home by saying;

For every one dollar generated by the company, $0.96 cents is used to pay for buying products, paying operating expenses, and for paying taxes. The other $0.04 cents remain in the company or is distributed to its owners.

Note: the higher the net profit margin, the more stable a company is considered. Moreover, a higher net profit margin indicates a company is more profitable, after all expenses and taxes have been paid. On the other hand, the lower a company's net profit margin, the less money it will have to pay for taxes and expenses, and therefore the less stable the company appears. The next profitability ratio is called Return on Total Assets.

RETURN ON TOTAL ASSETS:

Return on Total Assets is a ratio that measures how well a company is using its assets to generate profits. Below depicts how the Return on Total Assets Ratio is calculated;

As you can see, two items are required before a company can its calculate return on total assets; namely, Total Assets and Net Income After Taxes. As indicated earlier, Total Assets are the sum of a company's total current assets and its total fixed assets. Net Income After Taxes is calculated by subtracting a company's cost of goods sold, operating expenses and tax obligations from its revenues.

Total assets are shown on a company's balance sheet, while net income after taxes appears on its income statement. The Widget Manufacturing Company's balance sheet and income statement sections, needed for calculating their Return on Total Assets , are presented below.

Using the above figures, we can calculate the Widget Company's Return on Total Assets as of December 31, 200Y.

As you can see, the company's Return on Total Assets is 0.06 . This means, the company made $0.06 cents on every dollar it invested into assets. Let's drive the point home by saying;

For every one dollar invested into assets, the company generated 6 cents in after tax profits.

Remember, a company purchases assets so that it can generate profits. Therefore, the higher the Return on Total Assets ratio, the more stable a company is considered. Moreover, a higher Return on Total Assets ratio indicates a company is using its assets more efficiently to generate profits. On the other hand, the lower a company's Return on Total Assets ratio, the less they are using their assets to generate profits, and therefore the less stable the company appears. The next profitability ratio is called Return on Equity.

RETURN ON EQUITY:

Return on equity ratio is a measure of the rate of return on investment, in the enterprise, the owners have made. Below depicts how the return on equity ratio is calculated;

As you can see, two items are required before a company can calculate its return on equity; namely, Total Equity and Net Income After Taxes. As indicated earlier, Total Equity represents all the investments made into the company by its owners. Net Income After Taxes is calculated by subtracting a company's cost of goods sold, operating expenses and tax obligations from its revenues.

Total Equity is shown on a company's balance sheet, while a company's Net Income After Taxes appears on its income statement. The Widget Manufacturing Company's balance sheet and income statement sections, needed for calculating the Return on Equity ratio, is presented below.

Using the above figures, we can calculate the Widget Company's Return on Equity as of December 31, 200Y.

As you can see, the company's return on equity is 0.13 . This means, the company made $0.13 cents on every dollar the owners invested. Let's drive the point home by saying;

For every one dollar invested by the owners, the company generated 13 cents in after tax profit.

Remember, owners invest into a company so they can generate profits for themselves and their company. Therefore, the higher the return on equity ratio, the more stable a company is considered. Moreover, a higher return on equity indicates a company is using its owner's funds wisely to generate profits. On the other hand, the lower a company's return on equity ratio, the less efficient the owner's funds are being utilized to generate profits, and therefore the less stable the company appears.

Profitability Ratios Summary:
In summary, profitability ratios are of great importance to investors since they measure how effectively management is generating profits from the company's assets and from the owner's investments. The most common profitability ratios include; gross profit margin ratio, net profit margin ratio, return on total assets ratio, and the return on equity ratio. The gross profit margin is calculated by subtracting the cost of goods sold from the sales and dividing by the sales. The net profit margin is calculated by dividing a company's net income after taxes by its sales. Return on Total Assets is calculated by dividing a company's net income after taxes by its total assets. Return on Equity is calculated by dividing a company's net income after taxes by its total equity. Below summarizes the profitability ratios for the Widget Manufacturing Company as of December 31, 200Y.