Profitability ratios are a set of measurements used to determine the ability of a business to create earnings. These ratios are considered to be favorable when they improve over a trend line or are comparatively better than the results of competitors.
Profitability ratios are derived from a comparison of revenues to difference groupings of expenses within the income statement. The main ratios are as follows:
- Contribution margin ratio. Subtracts all variable expenses in the income statement from sales, and then divides the result by sales. This is used to determine the proportion of sales still available after all variable costs to pay for fixed costs and generate a profit. This is used for breakeven analysis.
- Gross profit ratio. Subtracts all costs related to the cost of goods sold in the income statement from sales, and then divides the result by sales. This is used to determine the proportion of sales still available after goods and services have been sold to pay for selling and administrative costs and generate a profit. This ratio includes the allocation of fixed costs to the cost of goods sold, so that the result tends to yield a smaller percentage than the contribution margin ratio.
- Net profit ratio. Subtracts all expenses in the income statement from sales, and then divides the result by sales. This is used to determine the net amount of earnings generated in a reporting period, net of income taxes. If the accrual basis of accounting is used, this can result in a figure that is different from what cash flows would indicate, due to the accrual of expenses that have not yet occurred.
A different class of profitability ratios compare the results listed on the income statement to the information on the balance sheet. The intent of these measurements is to examine the efficiency with which management can produce profits, in comparison to the amount of equity or assets at their disposal. If the outcome of these measurements is high, it implies that resource usage has been minimized. The main ratios in this category are:
- Return on assets. Divides net profits by the total amount of assets on the balance sheet. The measurement can be improved by using a tight credit policy to reduce the amount of accounts receivable, a just-in-time production system to reduce inventory, and by selling off fixed assets that are rarely used. The result varies by industry, since some industries require far more assets than others.
- Return on equity. Divides net profits by the total amount of equity on the balance sheet. The measurement can be improved by funding a larger share of operations with debt, and by using debt to buy back shares, thereby minimizing the use of equity. Doing so can be risky, if a business does not experience sufficiently consistent cash flows to pay off the debt.
When using profitability ratios, it is best to compare a company's results for the current period to the results for the same period in the preceding year. The reason is that many organizations have seasonal sales, which causes their profitability ratios to vary considerably over the course of a year.