Looks like we are rounding up with all the key financial ratios required in evaluating and analyzing the performance and overall well-being of a company for investment considerations.
As promised in my last blog, today I will share my knowledge of the profitability ratio, which is a ratio used in evaluating how well a company has returned or create wealth for its shareholders, retain profit per dollar of sales, and generate profits with their assets. The higher the ratios, the better for a company.
So, let’s start!
What is profitability Ratio:
In my own terms, I’ll say they are a set of tools used to determine the ability of a company to create returns to shareholders. These ratios are efficient when they improve year on year or are comparatively better than competitors.
- Profitability ratios assess a company’s ability to earn profits from its general operations and shareholders’ funds.
- Profitability ratios indicate how well a company generates profit, create wealth and value for shareholders.
- The higher the ratio, the more profitable the company is, but these ratios provide much more information when compared to results of similar companies, the company’s own historical performance, or the industry average.
Types of Profitability Ratio Use in Company Evaluation:
The Profit Margin: A couple of profit margins are used to measure a company’s profitability at various cost levels, including gross margin, operating 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:
This measures how much a company makes after accounting for cost of goods sold. Operating margin is the percentage of sales left after covering cost of goods sold and operating expenses.
- Net Profit Margin:
This is the company’s ability to generate earnings after all costs and taxes has been factored in.
- Return on Assets (ROA):
The profitability of a company is assessed relative to costs and expenses and analyzed in comparison to assets to see how well a company is sweating its assets to generate sales and profits. 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 over the period.
- Return on Equity:
ROE is a key ratio as it measures a company’s ability to earn a return on its equity investments. Return on equity can be calculated as net income over a period divided by shareholders’ equity, This may also increase without additional equity investments.
Basically, most companies refer to profitability ratios when analyzing business productivity, also to provide useful insights into the financial well-being and performance of a business. by comparing income to sales, assets and equity.
In my next blog, I will share my understanding of how to assess market value of a company relative to its peers.
Cheers everyone and Goodluck!
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