What Are Profitability Ratios?

The magic of Financial Metrics and ratios is that they can tell you a lot about a company. Financial ratio analysis relies on financial statements to study the past and develop a feel for a company’s attractiveness measured on factors such as its competitive position, financial strength and profitability.

Knowledge of financial ratios can give investors a feel for how a company might react to shifts in industry, financial and economic environments.

You can use ratios to evaluate the viability of a company as well as to compare it against other companies in similar industries. Examining the trend in ratios over time helps to identify improving or deteriorating conditions of a company. It is also important to keep in mind that these ratios are interrelated and should be examined together rather than independently.

One very helpful group of financial ratios you can examine when deciding whether or not to invest in a company are profitability ratios. We will delve into what profitability ratios measure, why investors focus on certain ones, as well as how you can use them to analyze a company’s potential and invest with confidence.

What Does Profitability Mean?

When investors and analysts are discussing how profitable a company is, they are specifically considering the degree to which a business or activity yields financial gain. Investors looking at multiple companies will want to use certain metrics and ratios to determine if it is worth investing in. Using the same measures to evaluate companies allows for an apples-to-apples comparison.

Profitability is typically defined as either a success or failure regarding a business’ ability to produce an adequate return based on its resources compared to an alternative investment. As we mentioned above, it is key to compare businesses in similar industries as well as use multiple Financial Metrics, not just profitability ratios, to analyze a company’s inherent value and financial strength.

What Are Profitability Ratios?

Profitability ratios are a group of metrics that measure a company’s ability to generate earnings relative to its expenses and other financial line items in a given period of time. They are a class of ratios that show both investors and analysts how well a company utilizes its assets to produce profit and value for shareholders.

In this specific ratio group, there are five main profitability ratios to focus on:

• Gross profit margin: The gross profit of a company is how much money is left after accounting for the cost of producing goods and services and paying workers. Gross profit margin indicates the amount of revenue remaining after deducting the cost of goods sold.
• Operating profit margin: The operating margin analyzes how much profit a company makes on a dollar of sales after paying for variable costs of production, such as wages and raw materials, but before paying interest or tax.
• Net profit margin: The net profit margin, or simply net margin, measures how much net profit is generated as a percentage of revenue. It is the ratio of net profits to revenues.
• Return on assets (ROA): Indicates how profitable a company has been or could be in relation to its overall assets.
• Return on equity (ROE): Measures the profitability of a company in relation to its shareholder equity.

Each one of these profitability metrics focuses on a specific variable an investor can use to help make an informed decision about investing in the company.

What Do Profitability Ratios Measure?

Profitability ratios measure two things: How effectively a company converts sales revenue into profits, which is a margin ratio like the gross, operating and net margins; and whether a business can effectively generate a profit for its owners or shareholders, which is a return ratio like return on assets or return on equity.

Overall, investors want to know that a company they may invest in has the potential to turn a healthy profit before they invest in it, and one way to do this is to use profitability ratios.

Lastly, profitability ratios are often compared with efficiency ratios, which consider how well a company uses its assets internally to generate revenue and income. Examples of efficiency ratios include receivables turnover and asset turnover. These ratios differ from profitability metrics in that they don’t consider the same financial data that profitability ratios do, such as after-cost profits.

Profitability ratios are intended to make it easier for investors and analysts to evaluate a company’s potential profitability.

How to Analyze Companies With Profitability Metrics

You will want to look at the individual profitability ratios to know if a company is profitable or not. Generally, there are two aspects that indicate a good profitability ratio:

1. The company has a higher value relative to a competitor’s ratio in the same industry, indicating that its business is generally more profitable overall.
2. The trend in a profitability ratio for a company shows improvement over time.

The key takeaway to properly evaluate a company based on profitability ratios is that they can only be useful when comparing similar companies or when looking at the company’s own history or average ratios for the company’s industry.

Where Do You Find Profitability Ratios?

Because profitability ratios are used so often in evaluating a company’s ability to generate regular revenue, they can easily be found on any brokerage or investor site.

On the AAII website, you can conveniently find gross, operating and net profit margin as well as ROE and ROA under the ratios section of a company’s Stock Evaluator page. You can also view these ratios over the last few years so you can better understand how the company has been progressing and any upward or downward movement regarding profitability.

Using Profitability Ratio Formulas to Invest

Utilizing Financial Metrics like profitability ratios helps investors gauge the future of a company and develop a feel for its attractiveness as measured on factors such as its competitive position, financial strength and profitability.

Knowledge of how to use profitability ratios gives investors a feel for how a company might react to shifts in industry, financial and economic environments. They can use these profitability metrics to see how well a company is generating revenue and earnings—which will impact share prices and shareholders—and whether it is becoming more or less efficient at controlling costs.

As mentioned above, AAII offers a long list of helpful educational tools, resources and stock metrics to help people invest their money wisely. Subscribing to our A+ Investor service provides members with customizable stock grades and screens, and new enhancements to the service are added quarterly.

Members can search any company on the AAII website to see specific stock metrics for different types of investing approaches, including ways to measure a company’s worth and viability with ratios.

You can use A+ Investor to vet various market securities like stocks, bonds, funds, etc., with key Financial Metrics, professional screens and power rankings. Start analyzing your stocks’ profitability ratios and overall performance today with A+ Investor.