The two categories of profitability ratios are margin ratios and return ratios. Margin ratios represent the firm's ability to translate sales dollars into profits. Return ratios measure the overall ability of the firm to generate shareholder wealth. These ratios can help you answer several important business questions.
- How good is your business at generating profit?
- Is performance getting better or worse?
- How much better could your business perform?
- How do you compare to other businesses?
Fertile ground for finding answers to these questions lies in computing and analyzing profitability ratios or financial metrics that assess a business's ability to generate earnings as compared to expenses and costs during a specific accounting period. In most cases, the same or higher value as compared to a previous period or a competitive benchmark is considered to be a mark that the company is doing well.
The Gross Margin
Gross margin is the amount of each dollar of sales that a company is able to keep in the form of gross profit. It is usually stated as a percentage. Gross profit, of course, is the difference between a company's sales or products and/or services and much it costs the company to provide those products and/or services. The higher the gross margin, the more profitable the company, but bear in mind that different industries may show, or benchmark, very different gross margins.
Gross Margin = (Gross Profit) / (Sales)
Operating margin measures, or a per dollar of sales basis, how much a company makes or loses from its primary business. As this metric considers not only the loss of sales but other components of operating income, such as marketing and overhead, it is considered to be more complete and a more accurate indicator of a company's ability to generate profit than gross margin.
Operating Margin = (Operating Income or Loss) / Sales
Net Profit Margin
Net profit margin measures the percentage of revenue a company keeps after all income and all expenses are logged or recorded. It's an important metric, but not quite as precise or actionable as others because it considers information that can be aside from a company's core business.
Net Margin = (Net Income or Loss) / Sales
Free Cash Flow Margin
To some business owners, nothing is more important than free cash flow - it is elemental to survival. Free cash flow margin measures how much per dollar of revenue management is able to convert into free cash flow.
Free Cash Flow Margin = (Free Cash Flow) / Sales
Return on Assets (ROA)
How efficient is your business on turning assets into profits? Restated, how effectively do your assets generate revenue? This is the purpose of the return on assets (ROA) calculation. Return on assets is generally stated in percentage terms, and higher is better, all else equal.
Return on Assets = (Net Income + Aftertax Interest Expense) / (Average Total Assets)
Return on Equity (ROE)
Also stated in percentages, return on equity (ROE) considers a company's return on its shareholders' investment. As before, the higher the percentage, the better.
Return on Equity = (Net Income) / (Average Shareholders' Equity)
Cash Return on Assets
Cash ROA is the amount of cash flow from operations divided by a firm's total assets. This is different than a typical return on assets calculation because it focuses on cash flow from operations (CFO) vs. net income. Using CFO is harder to get to the core figures, and thus it is considered to be a better indicator of true return. Increasing the cash return on assets means a company is generating more cash flow from every asset dollar. Comparing the cash return on assets, and a return on assets calculation that uses net income can potentially illustrate where cash flows are not increasing.
Cash Return on Assets = Cash Flow From Operations / CFO / Average Total Assets)