## Profitability Ratios Explained - Examples and Calculations

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;

 Gross Profit Margin     = Sales - Cost of goods sold Sales

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.

 Sales from Widgets \$112,500 Cost of Goods Sold (COGS) \$ 85,040 Gross Margin \$ 27,460

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

 Gross Profit Margin = Sales - Cost of goods sold Sales \$112,500 - \$ 85,040 \$112,500 0.24

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;

 Net Profit Margin           = Net income after taxes Sales

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.

 WIDGET MANUFACTURING COMPANY CONDENSED INCOME STATEMENT FOR YEAR ENDING DEC. 31, 200Y Sales from Widgets \$112,500 Cost of Goods Sold (COGS) \$ 85,040 Gross Margin \$ 27,460 Operating Expenses (Marketing & Administrative) \$ 18,950 Net Income Before Taxes \$ 8,510 Less: Income Taxes \$ 4,163 Net Income After Taxes \$ 4,347

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

 Net Profit Margin = Net income after taxes Sales = \$ 4,347 \$112,500 = 0.04

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;

 Return on Total Assets = Net income after taxes Total assets

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.

 FROM THE BALANCE SHEET FROM THE INCOME STATEMENT ASSETS: Current Assets: Cash \$  2,550 Sales from Widgets \$112,500 Marketable securities \$  2,000 Cost of Goods Sold \$ 85,040 Account Receivable (Net) \$16,675 Gross Margin \$ 27,460 Inventories \$26,470 Total Current Assets \$47,695 Operating Expenses \$ 18,950 Fixed Assets: Net Income Before Taxes \$ 8,510 Plant & Equipment \$41,000 \$ 11,000 Less: Income Taxes \$ 4,163 Net Plant & Equipment \$30,000 Net Income After Taxes \$ 4,347 TOTAL ASSETS \$77,695

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

 Return on Total Assets = Net income after taxes Total assets = \$ 4,347 \$77,695 = 0.06

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;

 Return on Equity = Net income after taxes Total Equity

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.

FROM THE INCOME STATEMENT
FROM THE BALANCE SHEET

###### Equity:
Sales from Widgets \$112,500
Common Shares \$25,000
Cost of Goods Sold \$ 85,040
Retained Earnings \$ 7,820
Gross Margin \$ 27,460
TOTAL EQUITY \$32,820

Operating Expenses \$ 18,950

Net Income Before Taxes \$ 8,510

Less: Income Taxes \$ 4,163

Net Income After Taxes \$ 4,347

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

 Return on Equity = Net income after taxes Total Equity = \$ 4,347 \$32,820 = 0.13

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.

 Gross Profit Margin = Sales - Cost of goods sold Sales = \$112,500 - \$ 85,040 \$112,500 = 0.24 Net Profit Margin = Net income after taxes Sales = \$ 4,347 \$112,500 = 0.04 Return on Total Assets = Net income after taxes Total assets = \$ 4,347 \$77,695 = 0.06 Return on Equity = Net income after taxes Total Equity = \$ 4,347 \$32,820 = .13

Categories: Financial