Profitability is the ability of a firm to generate earnings.
Analysis of profit is of
vital concern to stockholders because they derive revenue in the form of
dividends. Further, increased profits can cause a rise in market price, leading
to capital gains. Profits are also important to creditors because profits are one
source of funds for debt coverage. Management uses profit as a performance
measure.
In profitability analysis, absolute figures are less meaningful than earnings
measured as a percentage of a number of bases: the productive assets, the
owners’ and creditors’ capital employed, and sales.
Profitability Measures
Net Profit Margin
The net profit margin, or simply net margin, measures how much net income or
profit is generated as a percentage of revenue. It is the ratio of net profits to
revenues for a company or business segment. Net profit margin is typically
expressed as a percentage but can also be represented in decimal form. The net
profit margin illustrates how much of each dollar in revenue collected by a
company translates into profit.
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Total Asset Turnover
The asset turnover ratio measures the value of a company's sales or revenues
relative to the value of its assets. The asset turnover ratio can be used as an
indicator of the efficiency with which a company is using its assets to generate
revenue.
The higher the asset turnover ratio, the more efficient a company is at generating
revenue from its assets. Conversely, if a company has a low asset turnover ratio,
it indicates it is not efficiently using its assets to generate sales.
This metric helps investors understand how effectively companies are
using their assets to generate sales.
Investors use the asset turnover ratio to compare similar companies in the
same sector or group.
A company's asset turnover ratio can be impacted by large asset sales as
well as significant asset purchases in a given year.
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Return on Assets
ROA = NI / Average total assets
The term return on assets (ROA) refers to a financial ratio that indicates how
profitable a company is in relation to its total assets. Corporate management,
analysts, and investors can use ROA to determine how efficiently a company
uses its assets to generate a profit.
A higher ROA means a company is more efficient and productive at managing
its balance sheet to generate profits while a lower ROA indicates there is room
for improvement.
Operating Income Margin
The operating income margin includes only operating income in the numerator.
Compute the operating income margin as follows:
Operating Asset Turnover
This ratio measures the ability of operating assets to generate sales dollars.
Compute operating asset turnover as follows:
Return on Operating Assets
Adjusting for nonoperating items results in the following formula for return on
operating assets:
Return on Total Equity
The return on total equity measures the return to both common and preferred
stockholders. Compute the return on total equity as follows:
Return on equity (ROE) is a measure of financial performance calculated by
dividing net income by shareholders' equity. Because shareholders' equity is
equal to a company’s assets minus its debt, ROE is considered the return on net
assets. ROE is considered a gauge of a corporation's profitability and how
efficient it is in generating profits.
Return on Total Equity = NI/ Average total equity
Questions to practice
