**Profitability ratio: Introduction**

In the previous posts in this series covering Financial Analysis tools we have covered ** activity ratios**,

**and**

__liquidity ratios__**. In this post in the series we will cover the most important set of ratios – profitability ratios. At the end of the day all that really matters to anyone analyzing a firm’s performance is the profits made by the firm. Profitability ratios analysis serves to measure how profitable a firm has been in a given accounting period. A profitability ratio formula can comprise of income statement items or a mix of income statement and balance sheet items. So let’s see below the various types of profitability ratios commonly used for ratio analysis.**

__solvency ratios__**Profitability ratio: ‘Return on sales’ profitability ratios**

Return on sales ratios state the different returns found on the income statement as a percentage of the sales or revenue.

__Click here to see an income statement example or layout__

Following are the different types of ‘return on sales’ profitability ratios.

**Gross profit ratio**

Gross profit ratio is a profitability ratio that expresses the gross profit as a percentage of revenue or sales. Gross profit is **sales – cost of goods sold**. The ‘gross profit’ profitability ratio formula is given as;

Gross profit ratio = Gross profit / sales

A higher ratio is preferred. A higher ratio indicates the company is either able to sell its products at a higher price or produce them at low costs.

**Net Profit ratio**

Net profit ratio is a profitability ratio that expresses net income from continuing operations as a percentage of sales or revenue. Net profit is the **Gross profit – expenses – interest payments – taxes**. See the income statement example through the link given above to better understand what you are reading.

‘Net profit’ profitability ratio formula is given as;

Net profit ratio = net income from continuing operations / sales

Again a low ratio is a cause for concern.

**Operating profit ratio **

Operating profit or EBIT is the earnings before deducting interest and tax payments. Operating profit or EBIT is **Gross profit – operating expenses**. Operating profit ratio is a profitability ratio where the operating profit or EBIT is expressed as a percentage of sales.

‘Operating profit’ profitability ratio formula is given as;

Operating profit ratio = EBIT / sales

The higher the ratio the better it is.

**‘Pretax margin’ profitability ratio formula**

Pretax margin is calculated by expressing ‘EARNINGS BEFORE TAX’ i.e. ‘earnings after deducting interest payments but before deducting taxes payments’ (EBT) as a percentage of revenue or sales. The ‘pretax margin’ profitability ratio formula is given as;

Pretax margin = EBT / sales

This profitability ratio analysis tries to gauge the effect of leverage on the profitability of the company. A falling ratio indicates an increase in debt in the capital structure.

All the ‘return on sales’ profitability ratios mentioned above can be readily found in a ‘Common size Income Statement’ which has already been discussed in a past post.

__Click here to find out more about Common size Income Statements__

**Profitability ratio: ‘Return on Investment’ profitability ratios**

‘Return on investment’ profitability ratios analysis tries to measure the returns earned by the firm from the assets financed by owner’s capital and debt i.e. returns earned on the capital invested by the owner’s and suppliers of debt.

**Return on assets (ROA)**

** **Return on assets is the first among the ‘return on investment’ profitability ratios being discussed today. ‘Return on assets’ profitability ratio formula is given as;

ROA = Net income / average total assets

This formula however, doesn’t give a correct picture as net income is the income available only to equity holders, while the assets in the denominator is financed by both equity and debt holders.

Therefore the ratio needs to be calculated as;

ROA = Net income + gross interest expense (1 – tax) / average total assets

Here we have added back the gross interest expense (**and not** net interest expense which is interest expense – interest income) back to net income to get the income available for distribution to both equity and debt holders. We have adjusted it for taxes as net income is after tax.

An alternate way of calculating ROA is by getting income before interest and taxes , i.e. operating income or EBIT in the numerator so that income available to both equity and debt holders is included in the numerator. In this case the ROA ratio is given as;

ROA = EBIT / average total assets

**Return on Total capital**

‘Return on total capital’ profitability ratio is the ratio of net income before interest and taxes to total capital i.e. common stock, preferred stock, short term debt and long term debt. The Return on total capital formula is given as;

Return on total capital = EBIT / average total capital

**Return on equity (ROE)**

Return on equity or return on total equity as it is also called is the ratio of income available to all equity holders to total equity (common and preferred). The return on equity profitability ratio formula is given as;

ROE = EBIT / average total equity

**Return on common equity**

‘Return on common equity’ profitability ratio analysis tries to measure the return available to common stockholders as a percentage of common equity. The ‘Return on common equity’ profitability ratio formula is given as;

Return on common equity =Net income – pref. dividends/avg. common equity

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That’s all in this post…in the next post in this series we will study the ROE ratio more closely as we cover **DuPont analysis of ROE** and in the final post of the series we will look into **calculation of ratios used in equity and credit analysis**…see you then….

**For solved examples please refer to the CFA Institute books or CFA study notes. The problems can be easily solved using the CFA institute approved financial calculators. Please refer to the CFA exam policy and CFA calculator guide.**

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