Lesson 14
PROFITABILITY RATIO
GROUP 5: FINMGT 1201
Members:
Gonzales, Donna Mae
Guijoba, Shane Ysabelle
Gutierrez, Keycee Leth
Mendoza, Kyla
Panganiban, Angel
Platero, Princess Angeline
• What is Ratio Analysis?
Corporate finance ratios are quantitative measures that are used to assess
businesses. These ratios are used by financial analysts, equity research analysts,
investors, and asset managers to evaluate the overall financial health of businesses,
with the end goal of making better investment decisions. Corporate finance ratios are
also heavily used by financial managers and C-suite officers to get better
understanding of how their businesses are performing.
• Why use Ratio Analysis?
Ratio analysis is a great way to compare two companies that are different in
size operations and management style. It also is a great way to quantify how efficient
a company’s operations are and how profitable the business is set up to be.
• Types of Ratios
Corporate finance ratios can be broken down into four categories that measure
different types of financial metrics for a business:
1. Profitability Ratios
2. Leverage Ratios
3. Efficiency Ratios
4. Liquidity Ratios
5. Valuation Ratios
• Profitability Ratio
Profitability ratios are financial metrics used by analysts and investors to
measure and evaluate the ability of a company to generate income (profit) relative to
revenue, balance sheet assets, operating costs, and shareholders’ equity during a
specific period of time. They show how well a company utilizes its assets to produce
profit and value to shareholders.
A. Return Ratios
Return ratios represent the company’s ability to generate returns for its
shareholders. It typically compares a return metric versus certain balance sheet items.
1. Return on Equity
• Return on equity is a measure of a company’s annual return (net income) divided by
the value of its total shareholders’ equity, expressed as a percentage (e.g. 10%).
• ROE provides a simple metric for evaluating returns. By comparing a company’s
ROE to the industry’s average, it is possible to pinpoint a company’s competitive
advantage (or lack of competitive advantage).
• As it uses net income as the numerator, return on equity (ROE) looks at the firm’s
bottom line to gauge overall profitability for the firm’s owners and investors.
Formula:
ROE= Net Income
Shareholders’ Equity
2. Return on Assets
• Return on assets (ROA) is a type of profitability ratio that measures the profitability
of a business in relation to its total assets. This ratio indicates how well a company is
performing by comparing the profit (net income) it’s generating to the total capital it
has invested in assets. The higher the return, the more productive and efficient the
management is in utilizing economic resources.
• The ROA formula is an important ratio in analyzing a company’s profitability. The ratio
is typically used when comparing a company’s performance between periods, or when
comparing two different companies of similar size and industry.
Formula:
ROA= Net Income
Total Assets
3. Return on Capital Employed
• Return on Capital Employed (ROCE) is a profitability ratio that measures how
efficiently a company is using its capital to generate profits. The return on capital
employed is considered one of the best profitability ratios and is commonly used by
investors to determine whether a company is suitable to invest in.
• The return on capital employed shows how much operating income is generated for
each dollar invested in capital. A higher ROCE is always more favorable as it implies
that more profits are generated per dollar of capital employed.
Formula:
ROCE= EBIT / Capital Employed
B. Margin Ratios
Margin ratios represent the company’s ability to convert sales into profits at
various degrees of measurement. Margin ratios typically look at certain returns when
compared to the top line (revenue). Typically, it compares income statement items.
1. Gross Margin Ratio
• The gross margin ratio, also known as the gross profit margin ratio, is a profitability
ratio that compares the gross margin of a company to its revenue. It shows how much
profit a company makes after paying off its cost of goods sold (COGS). The ratio
indicates the percentage of each dollar of revenue that the company retains as gross
profit, so naturally a high gross margin ratio is desired.
• A low gross margin ratio does not necessarily indicate a poorly performing company.
It is important to compare gross margin ratios between companies in the same industry
rather than comparing them across industries.
Formula:
GMR= Gross Profit / Total Revenue × 100
2. Operating Profit Margin
• Operating profit margin is a profitability ratio used to calculate the percentage of profit
a company produces from its operations, prior to subtracting taxes and interest
charges. It is calculated by dividing the operating profit by total revenue and is
expressed as a percentage. The margin is also known as the EBIT (Earnings Before
Interest and Tax) margin.
Formula:
OPM= Operating Profit / Total Revenue × 100
3. Net Profit Margin
• Net profit margin (also known as “profit margin” or “net profit margin ratio”) is a
financial ratio used to calculate the percentage of profit a company produces from its
total revenue. It measures the amount of net profit a company obtains per dollar of
revenue gained.
• Net profit is calculated by deducting all company expenses from its total revenue.
The result of the profit margin calculation is a percentage – for example, a 10% profit
margin means for each $1 of revenue the company earns $0.10 in net profit. Revenue
represents the total sales of the company in a period.
Formula:
NPM= Net Income / Total Revenue × 100
Significance of Profitability Ratios
• Profitability ratios measure a company’s ability to generate consistent profits over
time.
• They reflect how effectively a business manages costs and investments to maximize
earnings.
• These ratios provide insights into a company’s financial performance, overall health,
and long-term sustainability.
• They are most useful when compared against industry benchmarks or competitors,
rather than being analyzed in isolation.
• A comparative approach helps businesses understand their market value and
competitive position.
Commonly Used Profitability Ratios
• Gross Profit Margin – Indicates the percentage of revenue that exceeds the cost of
goods sold (COGS), measuring production efficiency and pricing strategy.
• Operating Profit Margin – Assesses the profitability of a company’s core operations
by factoring in operating expenses, including sales, administrative costs, and COGS.
• Net Profit Margin – Reflects the portion of total revenue that remains as profit after
deducting all expenses, including taxes, interest, and operating costs.
Conclusion
• Profitability ratios help determine a company’s ability to generate profit from sales,
assets, and shareholders’ equity.
• They indicate how efficiently a business converts revenue into profit, providing
insights for investors and stakeholders.
• Higher profitability ratios generally suggest better financial performance and stronger
earnings potential.
• These ratios are valuable tools for comparing a company’s performance over time,
against competitors, or within its industry to guide strategic decision-making.
References:
Corporate Finance Institute. (n.d.). Profitability ratios. Corporate Finance Institute.
Retrieved March 29, 2025, from
https://corporatefinanceinstitute.com/resources/accounting/profitability-ratios
Investopedia. (n.d.). Profitability ratios. Investopedia. Retrieved March 29, 2025, from
https://www.investopedia.com/terms/p/profitabilityratios.asp
