Making Sense of Profits Using Profitability Ratios

Long-term investors buy shares of a company with the expectation that the company will produce a growing future stream of cash or earnings.

Profits point to the company’s long-term growth and staying power.

But “more” profits aren’t necessarily better than “less.” Oil companies have been in the headlines for generating “record profits” that are larger than any other firms in U.S. history. But from an investor’s standpoint, that doesn’t necessarily make them the most profitable firms.

That’s because profit figures are absolute numbers—they are simply a firm’s revenues less its costs. They don’t relate profits to the size of the company in terms of sales, its total resources or the amount of money investors have put into the company.

How can you put the numbers into context?

There are a number of financial ratios that help to measure the profitability of a firm.

Profits Relative to Sales

One way to measure the profitability of a firm is to relate a firm’s profits to its total sales. That is done using profit margin ratios. All of the figures used in these calculations can be found in a firm’s

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