Profitability Ratios

 

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Introduction

Profitability is a measure of net earnings, relative to components used to generate earnings. Profitability is also a measure of efficiency, providing evidence for how well a company utilizes things like assets or equity in order to generate both revenue and profit.

Measuring or evaluating profitability is important for gauging the quality of a company, as well as providing a basis for valuation as an enterprise or investment. Investors are especially concerned with profitability measures.

Despite being influenced by accounting conventions, earnings are still the most relevant and popular indication of a company’s ability to make money. Profitability ratios are important for defining the quality of a company’s earnings stream, and shed light on a company’s ability to generate cash.

 

Profit Margin

The profit margin ratio is an important measure and point of consideration for any user. It measures the total profit of a company relative to total sales. Expected ratio results can vary widely by industry type (for example, banks have very low profit margins). A negative result means the company reported a net operating loss for the period being analyzed.

This ratio is often expressed on a “net” basis, and referred to as “net profit margin”, and the denominator is generally expressed as “net sales” which rightly adjust total sales for any returns, allowances and discounts. There is no absolute benchmark and it is best to compare the ratio result to a relevant peer group in order to make a proper determination.

The main drawback to this ratio is that it does not explain the quality of the result. For example, if the result is low, the user does not know if the problem lies in high cost of goods sold, or high overhead or low sales volume, or other factor. Additional research is usually required to fully understand a ratio result.

  • Measures the degree of profitability after all direct or operational expenses
  • Usually calculated after the impact of net interest income / expense
  • Also known as pre-tax margin

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Gross Margin

Gross margin measures the relationship between sales and cost of goods sold. It is the first available measure of profitability on the income statement, specifically measuring the profitability inherent in a business before applicable overhead costs. A high gross margin is a welcome sign, indicating that production revenue is well in excess of total direct production costs. A low gross margin is cause for concern and further investigation. Peer group analysis will shed important perspective on this result.

The ratio can often be expressed in terms of “net revenue” as well, meaning gross sales less returns, Allowances or Discounts. This ratio should always result in a significantly positive number. If looking at interim statements, keep in mind that the gross margin can be affected by seasonality. Using annual statements will mitigate this possibility. The ratio is mostly relevant for companies with significant manufacturing activities such as an equipment producer or re-seller. This would not apply to service sector companies such as accounting or law firms that have no significant cost of goods.

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Effective Tax Rate

The