This is the second article in a four-part series on how to measure company profitability. Parts one, three, and four can be found here:
How to Measure Profitability, Part 1 - An explanation of profitability.
How to Measure Profitability, Part 2 - Defining profitability ratios.
(coming soon) How to Measure Profitability, Part 3 - comparing profitability of two companies.
How to Measure Profitability, Part 4 - Border Group Inc profitability just before bankruptcy.
So, how do we measure profitability? This can be a foggy and opinionated area, with many sources giving varying interpretations of which financial values are used to compute a given performance ratio. Further, what defines company profits, costs, and expenses may change depending on the industry the company operates in. If a company is a large conglomerate operating in many different industries, then you have much more work to do.
We will give you what we consider to be useful profitability ratios that are a starting place no matter what industry a company operates, and briefly explain why these ratios belong in your profitability analysis.
The Gross Profit Margin is the ratio of
gross profit to net sales. It measures how successful a company can control its costs, and how efficient they are able to generate profits from sales of its products or services.
The Pretax Margin combines net
earnings with company income tax then divides net sales. This ratio gauges how well a company can generate pre-tax profits given its sales, and show it can maintain low levels of operational expenses while keep its sales level strong.
The Net Profit Margin is the ratio of
net earnings to net sales. Dealing only with net values, this ratio reveals profit levels after all expenses are paid, and all costs associated with sales are deducted.
The Cash Return on Assets ratio is
the ratio of cash flow from operations to total assets. This ratio show positive results when a company generates strong cash flow given its investment in company assets. This can be a very industry-specific ratio.
The Gross Profit to Net Sales ratio
subtracts the cost of goods sold from net sales, revealing the gross profit, then divides net sales from the result. Although this calculation is the same as the Gross Profit Margin, the Gross Profit to Net Sales is meant to bring focus to the company’s ability to keep the costs of their sales low, showing how expenses can erode profits.
The Return on Equity ratio is the ratio
of net earnings to total stockholders equity. This ratio measures how well contributions from stockholders are generating earnings for the company. Generating earnings for stockholders is a primary goal of many companies, and this ratio provides a clear look into the company’s ability to deliver on this goal.
As you look at each ratio and its accompanying equation, you can see how each profitability ratio measures company profitability from a slightly different perspective. Each of these ratios exposes just a small amount of information. Used together, they can reveal how profitable a company is really operating.
In the next part of this series, we look two companies selling computer chips using their financial statements as a test of our profitability ratios and attempt to summarize their profitability levels.
Proceed to (coming soon) How to Measure Profitability, Part 3, or
go back to How to Measure Profitability, Part 1