In accounting, ratio analysis refers to a method that helps companies to gain insight into their liquidity, profitability, and operational efficiency by comparing financial data and information included in their financial statements.
Ratio analysis stands as a cornerstone of a company’s fundamental analysis.
In this article, we are going to take a deep look at profitability ratio and how it can be used as an investment tool. In fact, there are a few key investment tools that involve risk and profitability and some are more likely to pay off than others.
Measuring and understanding this ratio can be a useful starting point to assessing the quality of a company’s balance sheet. Then, we will take a look at other key ratios, and elaborate on their financial and fundamental importance in today’s global capital markets.
FINANCIAL RATIOS: EXPLAINED IN 35 SLIDES: CLICK TO PLAY
Measuring Return on Equity
According to Investopedia, ROE is one of the three most widely used measures of a company’s profitability, along with return on assets (ROA) and return on investment (ROI).
In plain English, the return on equity is the income a company generates from their investments. ROE measures how much profit the company generates for every dollar of investor equity.
Also referred to as the earnings per share (EPS) ratio, the ROE ratio indicates the percentage of a company’s total equity (or total market value) that is paid out as dividends, retained earnings or paid out as salaries, interest, bonuses, etc.
It is important to note that ROE is a ratio rather than a percentage. It measures a company’s profits relative to its total assets rather than relative to its equity.
ROE is calculated by dividing the net income or loss of a company by shareholders equity, divided by the total number of shares outstanding.
Furthermore, when viewed in conjunction with the price-to-book ratio, net income as a percentage of book value (or total assets) and the price-to-earnings (P/E) ratio, a company with a higher ROE typically holds a higher net income or lower price-to-book ratio.
How to Use the ROE Ratio
Based on the metric, below are a few examples of how it can be used to assess the financial health of a company.
A higher ROE indicates a company with a higher net income and/or cash flow that translates to better asset utilization and net profitability for investors. It’s important to note that a high ROE and/or high P/E ratio does not imply that the company is profitable.
Liquidity Ratios
Liquidity ratios are an important class of financial metrics used to determine a debtor’s ability to pay off current debt obligations without raising external capital. Liquidity ratios measure a company’s ability to pay debt obligations and its margin of safety through the calculation of metrics including the current ratio, quick ratio, and operating cash flow ratio.
Profitability refers to the financial performance of the business.
Types of Profitability Ratio
Gross Profit Ratio
Operating Ratio
Operating Profit Ratio
Net Profit Ratio
Return on Investment Ratio
Gross Profit Ratio
A business’s profit margin is the percentage of gross sales over total expenses that contributes to the bottom line of the business.
Gross profit ratio is a very useful tool for business owners to determine their profitability, as it represents sales minus costs.
Operating Ratio
Operating margin is the ratio between revenues and expenses. A company’s revenue is the amount it takes in and the expenses it pays out.
There are two types of operating margins. The first is operating profit margin, which represents the profit earned after paying all expenses. The second is operating margin excluding income tax, which accounts for expenses that were not paid out.
The ratio is a key performance indicator of a company, since profit margin usually equals the ratio between sales and costs, if all costs were allocated to sales.
The higher the operating margin, the more efficient the company is.
Net Profit Ratio
Net profit margin is the ratio between sales and operating income. It is similar to the gross profit ratio but it includes income taxes.
The higher the net profit margin, the better the profitability.
A higher net profit margin suggests a more profitable business.
Return on Investment Ratio
A higher return on investment indicates a more profitable company. The higher the ROI, the more profitable the company.
ROI, or Return on Invested capital is the return generated from an investment, or the return generated from the management’s activities. It is calculated as the profit generated after deducting investment costs.
ROI is a measure of a company’s financial efficiency. It is a metric to gauge the effectiveness of a management.
Return on Investment divided by Total invested capital indicates a company’s profitability. It is an important metric to measure the return from the company’s capital investments.
Return on Investment is a measure of efficiency, since capital investments have to be made in order to generate a profit, and efficiency is measured by how effective the capital is.
Some Other Profitability Ratios
Returns on Assets Ratio
A ratio that indicates a company’s profitability. Returns on Assets = Total Assets / Average Assets
Net Profit to Average Assets Ratio
An indication of profitability. The higher the net profit to average assets ratio, the more profitable the company
Ratio Formulae You Should Know To Compare With Peers
| Name of Financial Ratios | Formulae |
| Profitability Ratios | |
| Gross profit margin | Gross Profit / Revenue |
| Operating profit margin | Operating Profit / Revenue |
| Net profit margin | Net Profit / Revenue |
| EBITDA margin | EBITDA / Revenue |
| Cash flow margin | Cash flow from operating activities / Current Liabilities |
| ROA | Net Income / Total Assets |
| ROE | Net Income / Shareholder’s Equity |
| ROIC | Net Profit after Tax (Net Income – Dividend) / Total Invested Capital (Debt + Equity) |
| Liquidity Ratios | |
| Current ratio | Current Assets / Current Liabilities |
| Quick ratio | (Current Assets – Average Inventory ) / Current Liabilities |
| Working capital ratio | Current Assets – Current Liabilities |
| Solvency Ratios | |
| Solvency ratio | (Net Income + Depreciation) / Total Liabilities |
| Debt-to-equity ratio | Total Liabilities / Shareholders Equity |
| Debt-to-assets ratio | (Short-term Debts + Long-term Debts) / Total Assets |
| Debt-to-capital ratio | Total Debt / Total Capital (Debt + Shareholder’s Equity) |
| Efficiency Ratios | |
| Inventory Turnover ratio | COGS (cost of goods sold) / Inventory |
| Accounts Receivables Turnover ratio | Net Credit Sales / Average Accounts Receivables |
| Assets Turnover ratio | Revenue / Total Assets |
| Accounts Payables Turnover ratio | Net Credit Purchase / Average Accounts Payables |
