Profitability Ratios are used to evaluate management's ability to create earnings from revenue-generating bases within the organization. Profitability Ratios measure the earnings by dividing the earnings by a base, such as assets, sales or equity. Four common profitability ratios are:
Profit Margin on Sales = Net Income / Sales
Operating Margin on Sales = Earnings Before Interest & Taxes / Sales
Return on Assets = Net Income / Average Assets
Return on Equity = Net Income / Average Common Equity
Example : Net Sales (Gross Sales less Allowances) are $ 500,000.
Earnings Before Interest and Taxes are $ 50,000 and Net Income is $ 25,000. Asset Balances are: Beginning $ 190,000 and Ending $ 210,000
Common Stock Balances: Beginning $ 325,000 and Ending $ 325,000
Retained Earnings Balances: Beginning $ 100,000 and Ending $ 150,000.
Profit Margin = $ 25,000 / $ 500,000 = .05 or 5%
Operating Margin = $ 50,000 / $ 500,000 = .10 or 10%
Return on Assets = $ 25,000 / ($ 190,000 + $ 210,000) / 2 = .125 or 12.5%
Return on Equity = $ 25,000 / ($ 425,000 + $ 475,000) / 2 = .055 or 5.5%
Profitability ratios are widely used by creditors, investors, and others who are interested in finding out how management generates its earnings.
Written by: Matt H. Evans, CPA, CMA, CFM | Email: email@example.com | Phone: 1-877-807-8756