Profitability refers to the ability to generate income. In analyzing a company's financial statements, the most common profitability ratios used include: gross profit margin, net profit margin or return on sales, return on assets, and return on equity.
Gross profit margin, or gross profit rate, measures the percentage of gross revenues in relation to net sales. Gross profit is what remains of net sales after deducting the cost of merchandise sold (cost of sales). The formula for gross profit margin is:
Gross profit margin = Gross profit ÷ Net sales
where, Gross profit = Net sales - Cost of sales
If there are no changes to the selling price and cost of merchandise across different periods, the gross profit rate should be constant over the years, or very close if not constant.
The net profit margin (also known as "return on sales") is the percentage of net income to net sales. Net income the bottom line amount in the income statement. It represents the income left after all expenses and losses are deducted. The net profit margin is computed as follows:
Net profit margin = Net income ÷ Net sales
Return on assets represents the measure of return on investment in financial statement analysis. It determines the rate of return in using company resources to generate income. The formula in computing for return on assets is:
Return on assets = Net income ÷ Average total assets
Take note that since the net income covers a span of time, the total assets should be averaged for the two figures to be comparable.
The return on equity measures percentage of net income generated by stockholders' equity. It determines how profitable a company is in utilizing owner's investment and
Return on equity = Net income ÷ Average stockholders' equity
The above ratios measure the ability of a company to pay short-term obligations. They measure whether the company has enough current assets (or specific current assets) to meet current liabilities. These ratios provide an even useful insight when compared to benchmarks, such as past performance and industry averages.
Profitability ratios measure an entity's ability to generate income. They include:
