Profitability ratio is financial metrics that help evaluate how well a business can make money compared to its revenue, operating expenses, assets, or shareholders’ equity over time, based on data from a specific moment. They’re some of the most commonly used metrics in financial analysis.
These ratios provide insight into a company’s financial performance and overall health. It’s important to use them for comparison rather than looking at them in isolation.
You can also pair profitability ratios with efficiency ratios, which focus on how effectively a company utilizes its assets to generate income, rather than just looking at profits after costs.
What Insights Can You Gain from Profitability Ratios?
Profitability ratios give insight into how effectively a company’s management is running the business. Investors can use these ratios, along with other research, to figure out if a company is a solid investment choice.
In general, higher profitability ratios can highlight a company’s strengths and competitive edges, like the ability to set higher (or lower) prices for products and keep costs down.
These ratios are most valuable when compared to similar companies, the company’s past performance, or the average ratios within the industry. Typically, if a company’s current ratio is higher than its previous one, it suggests that the company is performing well.
Types of Profitability Ratio
Profitability ratios usually break down into two main types: margin ratios and return ratios.
- Gross margin
- Operating margin
- Pretax margin
- Net profit margin
- Cash flow margin
- Return on assets (ROA)
- Return on equity (ROE)
- Return on invested capital (ROIC)
Conclusion
Profitability ratios are a handy tool for companies, investors, and analysts to evaluate different parts of a company’s financial well-being. They mainly fall into two categories: margin ratios and return ratios.
Margin ratios look at how effectively a company can make money compared to its costs, while return ratios focus on how well a company utilizes its investments to create returns and build wealth for itself and its shareholders.