Table of Contents
The measures of profitability in business include various financial ratios and metrics that assess a company’s ability to generate earnings relative to its revenue, operating costs, balance sheet assets, or shareholders’ equity over time. Some common measures of profitability include:
1. Gross Profit Margin
Gross profit margin is a financial ratio that measures the profitability of a company’s core operations by comparing gross profit to revenue. It is calculated by subtracting the cost of goods sold (COGS) from net sales, and then dividing the result by net sales.
The resulting percentage represents the amount of each dollar of revenue that is left over after accounting for the direct costs of producing or delivering the company’s goods or services.
For example, if a company has $100,000 in net sales and $35,000 in COGS, the gross profit would be $65,000, and the gross profit margin would be 65% ($65,000 / $100,000). This means that for every dollar of revenue generated, $0.65 is retained as gross profit.
Gross profit margin is an important financial metric because it helps investors and analysts understand the efficiency of a company’s operations and its ability to generate profits from its core business activities.
A higher gross profit margin indicates that a company is generating more profit from its operations, while a lower gross profit margin may indicate that a company is facing challenges in controlling its costs or pricing its products appropriately.
It is important to note that gross profit margin should be compared to industry averages or to the company’s own historical performance to provide meaningful insights. Additionally, gross profit margin is just one of several financial ratios that should be considered when evaluating a company’s financial health and performance.
2. Return on assets (ROA)
Return on Assets (ROA) is a financial ratio that measures the profitability of a company in relation to its total assets. It shows how well a company is utilizing its assets to generate earnings and indicates the efficiency of the company’s management in generating profits from its economic resources.
The ROA formula is calculated by dividing a company’s net income by its average total assets, and then multiplying the result by 100 to convert the final figure into a percentage.
For non-financial companies, the formula can be adjusted to add back interest expenses due to inconsistencies in debt and equity capital.
The ROA ratio is used by investors and analysts to assess a company’s profitability, efficiency, and overall financial health. It is important to note that ROA should not be compared across industries, as companies in different industries vary significantly in their use of assets. Instead, it should be used to compare companies within the same industry. A higher ROA indicates that a company is more profitable and efficient in generating income for investors.
3. Return on Equity (ROE)
Return on Equity (ROE) is a financial ratio that measures the profitability of a company in relation to its shareholders’ equity. It is calculated by dividing net income by shareholders’ equity, expressed as a percentage.
ROE indicates how well a company uses its shareholder equity to generate profits. It is especially useful for comparing the performance of companies in the same industry. ROEs of 15-20% are generally considered good.
The DuPont formula, also known as the strategic profit model, decomposes ROE into three actionable components: net profit margin, asset turnover, and accounting leverage. This allows for a better understanding of changes in ROE over time and the drivers of value.
ROE is also used in stock valuation, but predicting stock value based on ROE alone is dependent on too many other factors to be of use by itself. ROE must be compared to the historical ROE of the company and the industry’s ROE average to be meaningful. Additionally, ROE can be influenced by debt, share buybacks, and the treatment of intangible assets in shareholders’ equity calculations.
4. Net Profit Margin
Net profit margin is a financial metric that measures the profitability of a company by comparing its net income to its total revenue. It is calculated by dividing net income by total revenue and expressing the result as a percentage.
Net profit margin provides insight into the efficiency of a company’s operations and its ability to generate profits from its revenue.
A higher net profit margin indicates that a company is generating more profits from its revenue, while a lower net profit margin indicates that a company is generating less profits from its revenue. It is a useful metric for comparing the profitability of companies within the same industry or for tracking the profitability of a company over time.
5. Earnings per Share (EPS)
Earnings per share (EPS) is a financial metric used to determine the portion of a company’s profit allocated to each outstanding common share. It is calculated by dividing net income available to shareholders by the weighted average number of common shares outstanding.
EPS is an important measure for investors and analysts to assess a company’s performance, predict future earnings, and estimate the value of the company’s shares. The higher the EPS, the more profitable the company is considered to be and the more profits are available for distribution to its shareholders.
There are two types of EPS: basic and diluted. Basic EPS is calculated using the net income available to shareholders and the weighted average number of common shares outstanding. Diluted EPS, on the other hand, is calculated by considering all potential dilutive securities that could increase the number of common shares outstanding, such as convertible bonds, convertible preferred shares, stock options, or warrants. Diluted EPS is always smaller than basic EPS because it includes the impact of these dilutive securities.
EPS is typically used in conjunction with a company’s share price to determine whether it is relatively “cheap” or “expensive” by calculating the price-to-earnings (P/E) ratio. A higher EPS indicates better profitability, and between two companies in the same industry with the same number of shares outstanding, the company with the higher EPS is considered more profitable.
6. Price-Earnings Ratio (P/E ratio)
The Price-Earnings Ratio (P/E Ratio) is a financial tool used to assess a company’s market value by dividing the current price of a common share by the earnings per share (EPS). It helps investors and analysts determine how much they are willing to pay for a share of a company compared to its net income.
The P/E ratio is calculated by taking the unit price of a company share on the financial markets and dividing it by the earnings per share.
A lower P/E ratio is generally preferable, as it indicates that a company’s stock is undervalued compared to its earnings. A higher P/E ratio can indicate that a company’s stock is overvalued, meaning investors are paying more for each dollar of the company’s earnings. The P/E ratio is often used to compare companies within the same sector or industry to determine which stocks are overvalued or undervalued.
7. Dividend Payout Ratio
The Dividend Payout Ratio is a financial metric that assesses the proportion of a company’s net income that is distributed to shareholders in the form of dividends. It is calculated by dividing the total dividends paid by the company by the net income generated during the same period.
The Dividend Payout Ratio helps investors understand how much of a company’s earnings are being returned to shareholders as dividends, with the remaining portion typically retained by the company for growth and reinvestment.
A higher Dividend Payout Ratio indicates that a larger percentage of earnings is being distributed as dividends, while a lower ratio suggests that the company is retaining more earnings for future growth.
8. Free Cash Flow (FCF)
Free Cash Flow (FCF) is a measure of a company’s financial performance, calculated by subtracting capital expenditures from operating cash flow. It shows the cash that a company can produce after deducting the purchase of assets such as property, equipment, and other major investments from its operating cash flow. FCF measures a company’s ability to produce cash that is available to be distributed in a discretionary way.
The formula for calculating FCF is:
Free Cash Flow (FCF) = Operating Cash Flow – Capital Expenditures
Operating Cash Flow (CFO) can be calculated using the following formula:
CFO = Net Income + Non-Cash expenses – Increase in Non-Cash Net Working Capital
Non-Cash expenses include items such as depreciation, amortization, stock-based compensation, impairment charges, and gains/losses on investments.
Capital Expenditures (CapEx) can be calculated by taking the value of the company’s property, plant, and equipment (PP&E) from the current year or other period, subtracting the PP&E figure from the prior period, and adding back in depreciation charges for the current period.
Free Cash Flow is an important metric for investors and analysts because it provides insight into a company’s financial health and its ability to generate cash. A high level of FCF indicates that a company is generating significant cash from its operations, while a low or negative level of FCF may suggest that a company is not generating enough cash to cover its expenses or invest in its business.
FCF is also used in financial modelling, such as Discounted Cash Flow (DCF) models, which value companies based on the timing and amount of their future cash flows.
In conclusion, These measures of profitability are essential for evaluating a company’s financial health, performance, and ability to generate returns for investors. They provide valuable insights into a company’s operational efficiency, profitability, and overall financial performance.
Difference between Gross Profit and Net Profit
Gross profit and net profit are two important measures of a company’s financial performance. The difference between gross profit and net profit is operating expenses and taxes.
| Gross profit | Net profit |
| Gross profit is the money made from sales, also known as revenue, minus the direct costs of providing the goods and services sold, also known as the cost of goods sold (COGS). It is a measure of the profitability of a company’s core operations, before accounting for operating expenses, interest, taxes, depreciation, and amortization. | Net profit, on the other hand, is the money left after paying for all expenses and taxes. It is a measure of the profitability of a company’s operations, after accounting for all costs, including operating expenses, interest, taxes, depreciation, and amortization. |
| Gross profit shows how much money a business makes after meeting some costs, but it does not account for all expenses, and it does not guarantee a net profit. | Net profit is the final profit figure, and it is the amount of money that can be distributed to business owners or reinvested into the business. |
| Gross profit is a measure of the profitability of a company’s core operations | Net profit is a measure of the overall profitability of the business, including the effects of overhead, theft, and other operational costs |
| Gross profit is an important measure of a company’s efficiency in producing and selling its products | Net profit is a crucial measure of the overall financial strength of the business |
In summary, gross profit is the money made from sales minus the direct costs of providing the goods and services sold, while net profit is the money left after paying for all expenses and taxes. Gross profit is a measure of the profitability of a company’s core operations, while net profit is a measure of the overall profitability of the business. The difference between gross profit and net profit is operating expenses and taxes.
Limitations of using gross profit margin as a measure of profitability
Gross profit margin is a measure of profitability that focuses solely on the direct costs of goods sold, reflecting the efficiency of core business operations. However, it has certain limitations as it only considers direct costs and does not account for all expenses, including operating costs, taxes, interest, and non-cash items. Therefore, it may not provide a complete picture of a company’s overall profitability and ability to generate earnings for shareholders.
To overcome these limitations, you also need to analyze net profit margin, which considers all expenses, including operating costs, taxes, interest, and non-cash items. Net profit margin provides a more comprehensive understanding of a company’s financial health and its ability to generate earnings for shareholders.
Difference between profitability ratios and return on investment (roi)
Profitability ratios and Return on Investment (ROI) are related concepts that measure the financial performance of a business or investment.
| Profitability Ratios | Return on Investment | |
| 1 | Profitability ratios are a group of financial metrics that assess a company’s ability to generate earnings relative to its revenue, operating costs, balance sheet assets, or shareholders’ equity over time. Examples of profitability ratios include gross profit margin, net profit margin, return on assets (ROA), return on equity (ROE), and earnings per share (EPS). These ratios provide insights into a company’s operational efficiency, profitability, and ability to generate returns for investors. | Return on Investment (ROI) is a specific profitability ratio that measures the return on an investment relative to its cost. ROI is calculated by dividing the net profit or gain from an investment by its cost and expressing the result as a percentage. For example, if an investment cost $1,000 and generated a net profit of $200, the ROI would be 20%. ROI is a widely used metric for evaluating the profitability of an investment or comparing different investment options. |
| 2 | ROI is more focused on the return on a specific investment, | while profitability ratios provide a broader view of a company’s overall financial health and performance |
| 3 | ROI is often used to evaluate individual investments or projects | while profitability ratios are used to assess the overall performance of a company or business unit. |
*Return Ratios: Return on Assets (ROA): Measures how efficiently a company uses its assets to generate earnings. This includes ROA and ROE
*Margin Ratios: Gross Margin: Indicates how much a company makes after accounting for the cost of goods sold (COGS). This Includes NPM and GPM
Continue reading: What is EBITDA and how does it affect valuation of a business ?