Calculating Profitability Ratios

Learning outcome

  • Calculate and interpret profitability ratios

Profitability Ratios

Profitability ratios are a measurement of how efficiently a company is being managed and run.  More than any other type of ratio, profitability ratios provide owners and managers with information about a business’s ability to use its resources to generate a profit.

  1. Net-Profit-on-Sales Ratio. This ratio measures a company’s profit per dollar of sales. The ratio is expressed as a percentage and shows the percentage of each dollar remaining after paying expenses. The ratio is calculated as follows:

Net Profit on Sales = Net Profit/Net Sales

For a small, privately owned company this ratio generally ranges from 3 to 7%, but like many of the other ratios we have discussed it varies based on the industry. Retail businesses generally have a net profit on sales ratio between 2 and 4% but other industries such as the healthcare industry have ratios as high as 15%.  When businesses see their net profit on sales ratio fall, they often undertake drastic cost-cutting measures. This is not always the best approach as many times cost reduction measures have a negative impact on the overall health and future of the business. Rather, businesses should look at their gross margin in comparison to similar businesses or their industry.  If their gross sales are comparable, then it makes sense for the business to investigate what in their operations is driving less revenue to the bottom line (net profit).

  1. Net-Profit-to-Assets Ratio. This ratio is also referred to as a return-on-assets ratio because it measures how much profit a company is generating for every dollar it has invested in the assets of the company. This ratio is calculated as follows:

Net Profit to Assets Ratio= (Net Profit)/(Total Assets)

This ratio provides information about how “asset intensive” a business or industry is. Manufacturing companies that require expensive machinery to produce a product will have a much lower net profit to asset ratio than an accounting firm, for instance. Again, this is a comparative ratio. A business will look at the industry average for similar businesses to determine if changes need to be made in how assets are utilized in the course of day-to-day operations.

  1. Net-Profit-to-Equity Ratio. This ratio is often referred to as a return on net worth ratio because it measures the owner’s return on investment (ROI). It reflects the percentage of the owner’s investment in the business that is returned annually via the profit of the business. It is one of the most important ratios when evaluating the company’s overall profitability. This ratio is computed as follows:

Net Profit to Equity Ratio= (Net Profit)/(Owners Equity)

One of the most common uses for this ratio is in comparison to a company’s cost of capital (interest rate on money borrowed). The business should produce a rate of return (ROI) that exceeds its cost of capital.

In general, ratios are useful in measuring a firm’s overall performance and identifying areas where the firm can improve. In addition to being able to calculate these ratios, owners and managers must understand how to interpret them in order to increase efficiency and profitability. Ratio analysis is an ongoing process, comparing the ratios not only to industry benchmarks but also to the company’s own ratios from prior periods.