Ratios that measure the income or operating success of a company for a given period of time are

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Profitability ratios are a class of financial metrics that are used to assess a business's ability to generate earnings relative to its revenue, operating costs, balance sheet assets, or shareholders' equity over time, using data from a specific point in time.

Profitability ratios can be compared with efficiency ratios, which consider how well a company uses its assets internally to generate income (as opposed to after-cost profits).

• Profitability ratios assess a company's ability to earn profits from its sales or operations, balance sheet assets, or shareholders' equity.
• Profitability ratios indicate how efficiently a company generates profit and value for shareholders.
• Higher ratio results are often more favorable, but these ratios provide much more information when compared to results of similar companies, the company's own historical performance, or the industry average.

For most profitability ratios, having a higher value relative to a competitor's ratio or relative to the same ratio from a previous period indicates that the company is doing well. Profitability ratios are most useful when compared to similar companies, the company's own history, or average ratios for the company's industry.

Gross profit margin is one of the most widely used profitability or margin ratios. Gross profit is the difference between revenue and the costs of production—called cost of goods sold (COGS).

Some industries experience seasonality in their operations. For example, retailers typically experience significantly higher revenues and earnings during the year-end holiday season. Thus, it would not be useful to compare a retailer's fourth-quarter gross profit margin with its first-quarter gross profit margin because they are not directly comparable. Comparing a retailer's fourth-quarter profit margin with its fourth-quarter profit margin from the previous year would be far more informative.

Profitability ratios are one of the most popular metrics used in financial analysis, and they generally fall into two categories—margin ratios and return ratios.

Margin ratios give insight, from several different angles, on a company's ability to turn sales into a profit. Return ratios offer several different ways to examine how well a company generates a return for its shareholders.

Some common examples of profitability ratios are the various measures of profit margin, return on assets (ROA), and return on equity (ROE). Others include return on invested capital (ROIC) and return on capital employed (ROCE).

Different profit margins are used to measure a company's profitability at various cost levels of inquiry, including gross margin, operating margin, pretax margin, and net profit margin. The margins shrink as layers of additional costs are taken into consideration—such as the COGS, operating expenses, and taxes.

Gross margin measures how much a company makes after accounting for COGS. Operating margin is the percentage of sales left after covering COGS and operating expenses. The pretax margin shows a company's profitability after further accounting for non-operating expenses. The net profit margin is a company's ability to generate earnings after all expenses and taxes.

Profitability is assessed relative to costs and expenses and analyzed in comparison to assets to see how effective a company is deploying assets to generate sales and profits. The use of the term "return" in the ROA measure customarily refers to net profit or net income—the value of earnings from sales after all costs, expenses, and taxes. ROA is net income divided by total assets.

The more assets a company has amassed, the more sales and potential profits the company may generate. As economies of scale help lower costs and improve margins, returns may grow at a faster rate than assets, ultimately increasing ROA.

ROE is a key ratio for shareholders as it measures a company's ability to earn a return on its equity investments. ROE, calculated as net income divided by shareholders' equity, may increase without additional equity investments. The ratio can rise due to higher net income being generated from a larger asset base funded with debt.

Learning Outcomes

• Define financial statement analysis

We previously introduced the four financial statements. We discussed how these statements provide information about a company’s performance and financial position. Here, we extend this discussion by showing you specific tools you can use to analyze financial statements in order to make a more meaningful evaluation of a company.

Ratio Analysis

Ratio analysis expresses the relationship among selected items of financial statement data. A ratio expresses the mathematical relationship between one quantity and another. For analysis of the primary financial statements, we classify ratios as:

• Liquidity ratios measure the short-term ability of the company to pay its maturing obligations and to meet unexpected cash needs.
• Operating efficiency ratios measure how efficiently a firm is paying its bills, collecting cash from customers, and turning inventory into sales.
• Profitability ratios measure the income or operating success of a company for a given period of time.
• Solvency ratios measure the ability of the company to survive over a long period of time.

Comparative Analysis

A single ratio by itself is not very meaningful. Accordingly, we will use various comparisons to shed light on company performance:

1. Intracompany comparisons covering two years for the same company.
2. Industry-average comparisons based on average ratios for particular industries.
3. Intercompany comparisons based on comparisons with a competitor in the same industry.