What Can I Learn from Profitability Ratios?

The profitability ratios include: operating profit margin, net profit margin, return on assets and return on equity.

Profit margin measures how much a company earns relative to its sales. A company with a higher profit margin than its competitor is more efficient. There are two profit margin ratios: operating profit margin and net profit margin. Operating profit margin measures the earnings before interest and taxes, and is calculated as follows:

Gross Profit Margin =

Profits Before Interest and Taxes

Sales

Net profit margin measures earnings after taxes and is calculated as follows:

Net Profit Margin =

Profits After Taxes

Sales

When asked for a ratio you simply put either gross or net profit x100 over the total sales.

While it seems as if these both measure the same numbers, their results can be dramatically different due to the impact of interest and tax expenses. Similarly, the next two ratios appear to be similar but they tell different stories. As an investor, banker or any other interested stakeholder, you are interested in getting a return on your investment. So are a company and its shareholders!

Return on capital employed (ROCE)) tells how well management is performing on all the firm’s resources. However, it does not tell how well they are performing for the shareholders. It is calculated as follows:

Return on Capital employed

Net profit before Taxes and interest

Total Capital Employed

These ratios are easy to calculate and the information is readily available in a company’s annual report.