Week 4 Profitability Ratios
Profitability Ratios
As mentioned previously, these types of ratios indicate if the firm is making any money, and how much in relation to what's invested. They also give you an indication of how the firm is doing in controlling its costs. For the purposes of this course we will discuss six profitability ratios —Gross Profit Margin, Operating Profit Margin, Net Profit Margin, Earnings Per Share, Return on Assets, and Return on Equity.
| Ratio | Formula |
| Gross Profit Margin |
Gross Profits Sales |
| For Amalgamated Hat Rack in 2016: |
1,600,000 3,200,000 |
= | .50 or 50% |
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Gross Profit is Sales minus Cost of Goods Sold (COGS). So the gross profit margin ratio measures the proportion of each sales dollar that remains after the goods that were sold are paid for. |
| Operating Profit Margin |
Operating Profit Sales |
| Note: Operating Profit is also called Earnings before Interest and Taxes, or EBIT, so you will sometimes see the ratio written as: | Operating Profit Margin | = |
EBIT Sales |
|
| For Amalgamated Hat Rack in 2016: |
757,500 3,200,000 |
= | .237 or 23.7% |
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Operating Profit is Sales minus COGS minus operating expenses, but NOT including non-operating expenses like interest and taxes. So the operating profit margin ratio measures the proportion of each sales dollar that remains after the firm’s products that were sold and normal operating expenses are paid for. |
| Net Profit Margin |
Net Income Sales |
| For Amalgamated Hat Rack in 2016: |
347,500 3,200,00 |
= | .109 or 10.9% |
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Net Profit is Sales minus all expenses, including interest and taxes. So the net profit margin ratio measures the proportion of each sales dollar that remains after all expenses are paid for. |
| Earnings Per Share (EPS) |
Net Income Number of Shares of Common Stock Outstanding |
| Note: The textbook does not tell us how many shares of common stock Amalgamated Hat Rack had outstanding at the end of 2016, so for the purpose of calculating this ratio let us assume that 50,000 shares are outstanding. | ||||
| For Amalgamated Hat Rack in 2016: |
347,500 50,000 |
= | $6.95 |
| Return on Assets (ROA) |
Net Income Total Assets |
| This is the measure of the overall firm's investment success how much it got for the amount of assets employed. | ||||
| For Amalgamated Hat Rack common stockholders in 2016: |
347,500 3,461,000 |
= | .1004 or 10.04% |
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So in 2016 Amalgamated Hat Rack earned slightly over a dollar for every $1 of assets deployed. Again, whether this is viewed as good or bad depends on the ROA ratio in past years, and on what other companies in the industry achieved. For example, Amalgamated Hat Rack earned $1.00 for every $1 of assets deployed in 2016, making its ROA ratio 10.0%. If the average firm in Amalgamated’s industry earned, say, $1.50 for every $1 of assets deployed, making their ROA ratio 15%, then we would look very unfavorably on Amalgamated’s results.) |
| Return on Equity (ROE) |
Net Income Total Common Equity |
| For Amalgamated Hat Rack common stockholders in 2016: |
347,500 1,785,000 |
= | .194 or 19.4% | |
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This is the common stockholder's "bottom line" what their return on their investment was. Investors compare this to other investments, like money market accounts, etc. to evaluate the return the firm produced for them. |