Investors and creditors continuously evaluate the financial strength and performance of a company to monitor their investments. This evaluation frequently utilizes financial ratios to analyze profitability of a company, and to compare the results with competitors that operate in the same industry. All profitability ratios focus on the bottom line, but each variation reports it from a different perspective.
Return on Assets
The return on assets (ROA) ratio reports the profit a company generates for each dollar it invests in its assets. To calculate the ROA ratio, divide a company’s net income by its total average assets. Calculating total average assets requires you to obtain the beginning and ending asset balances from the company’s balance. For example, if XYZ, Inc. reports net income of $6 million in 2011, and its balance sheet reports an asset balance of $2 million on Jan. 1, 2011 and a balance of $4 million at Dec. 31, 2011, the company’s average asset balance is $3 million. As a result, the ROA is equal to $2. This means that for every dollar of assets the company owns, it generates $2 of profit.
Return on Equity
The return on equity (ROE) ratio is similar to the ROA ratio in that it reports how effective company management is at generating profit with investors’ capital. However, ROE is more precise than ROA because it ignores the role that company liabilities play in generating profit. You can calculate the ratio as net income divided by average equity. To illustrate, suppose XYZ, Inc. reports a beginning equity balance of $1 million and an ending balance of $2 million on its balance sheet. Dividing the $6 million of net income by the average equity balance of $1.5 million yields an ROE ratio of $4. This means the company generates $4 of profit for every dollar of equity investors have in the company.
Gross Profit Margin
Gross profit margin (GPM) measure the percentage of revenue that remains after a company covers its operating expenses, also known as cost of goods sold (COGS). However, the GPM doesn’t measure a company’s overall profit as it ignores the general, selling and administrative expenses that don’t directly relate to generating revenue. To calculate the ratio, divide total sales by the COGS. For example, suppose XYZ, Inc. earns $5 million in revenue from the products it manufactures and incurs $2.5 million of operating expenses. This results in a GPM of 2:1, which indicates that 50 percent of revenue covers COGS or operating expenses. However, what the GPM doesn’t tell you is whether the company reports net income or a loss on its financial statements.
Analyzing Profitability Ratios
Whenever you evaluate a company using profitability ratios, you need to understand the limitations. In most cases, the ratios provide limited insight unless you analyze trends over a number of years and compare it to financial results of its competition. For example, you may initially find XYZ’s ROA to be quite impressive at $2. However, without knowing that XYZ’s three main competitors report ROA’s of $18, $22 and $55, the ratio by itself doesn’t provide much help.