Profitability reflects a company’s competitive position in the market and, by extension, its management quality. Profitability ratios measure the return earned by the company during a period. Return-on-sales profitability ratios express various subtotals on the income statement as a percentage of revenue. Return-on-investment profitability ratios measure income relative to the company’s assets, equity, or total capital employed. Different types of profitability ratios include:
Gross Profit Margin Ratio
The gross profit margin ratio indicates the percentage of revenue available to cover operating and other expenses and to generate profit. A higher gross profit margin indicates some combination of higher product pricing and lower product costs. If a product has a competitive advantage, the company is better able to charge more for it. On the cost side, a higher gross profit margin can also indicate that a company has a competitive advantage in product costs.
Net Profit Margin Ratio
Net profit is calculated as revenue minus all expenses. Net income includes recurring and non-recurring components. Generally, the net profit used in calculating the net profit margin ratio is adjusted for non-recurring items to offer a better view of a company’s potential future profitability.
Return on Total Asset Ratio
The return on total assets measure reflects the return on all assets invested in the company, whether financed with liabilities, debt, or equity. The higher the return on total assets ratio, the more income is generated by a given level of assets. The lower ratio reflects the lower-income is generated from a given level of assets.
Return on Common Equity Ratio
The return on common equity ratio measures the return earned by a company only on its common equity. The higher the ratio, the company utilizes its common equity well and vice–versa.
Operating Profit Margin Ratio
An operating profit margin increasing faster than the gross profit margin can indicate improvements in controlling operating costs such as administrative overheads. In contrast, a declining operating profit margin could be an indicator of deteriorating control over operating costs.
Debt Coverage Ratios
Debt coverage ratios are also known as solvency ratios. Debt coverage ratios are primarily of two types. Debt ratios, the first type, focus on the balance sheet and measure the amount of debt capital relative to equity capital. Coverage ratios, the second type, focus on the income statement and measure a company’s ability to cover its debt payments. These ratios are useful in assessing a company’s solvency and, therefore, in evaluating the quality of a company’s bonds and other debt obligations.
The Main Types of Debt Ratios
Debt-to-assets ratio
This ratio measures the percentage of total assets financed with debt. Generally, higher debt means higher financial risk and, thus, weaker solvency. Lower debt indicates higher solvency.
Financial leverage ratio
This ratio is also known as the leverage ratio. It measures the total assets supported for each money unit of equity. The higher the financial leverage ratio, the more leveraged the company is to use debt and other liabilities to finance assets.
Interest coverage ratio
This ratio is sometimes referred to as ‘times interest earned.’ It measures the number of times a company’s EBIT (earnings before interest and taxes) could cover its interest payments. A higher interest coverage ratio indicates stronger solvency, offering greater assurance that the company can service its debt from operating earnings.
Market value ratio
Market value ratios relate an observable market value, the stock price, to book values obtained from the company’s financial statements. The most common market value ratio is:
Earnings per share ratio
Earnings per share determine the portion of a company’s profit allocated to each outstanding share of common stock. It serves as an indicator of a company’s profitability. When calculating, it is more accurate to show the weighted average number of shares outstanding over the reporting term because the number of shares outstanding can change over time.
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