Profitability Ratio

9 Key excerpts on "Profitability Ratio"

• 

  eBook - ePub

  Accounting for Non-Accountants

  • David Horner(Author)
  • 2017(Publication Date)
  • Kogan Page

    (Publisher)

  Profit and profitability are not the same thing. Profit represents an absolute figure which is, broadly speaking, revenue less expenses. Profitability is concerned with looking at the profits earned in relation to some other variable such as sales or capital. Analysing profitability will involve looking at the manner in which the firm is generating profit, or its potential to generate future profits.

  We can use accounting ratios to help us assess how well a firm is performing. An accounting ratio is the comparison of two or more pieces of financial data which, once combined, aim to give much more meaningful and useful information about business performance.

  In this chapter we will consider what each ratio indicates in terms of assessing business performance and how it is calculated.

  Types of accounting ratio

  There are many different accounting ratios which can be calculated and they all attempt to enable us to interpret business performance. The different ratios can be categorized according to what particular aspect of business performance they are designed to assess. Although there is no definitive method of classifying ratios, the following groupings are fairly typical:

  • Profitability Ratios: Assess measures of profits in relation to sales, capital and other financial variables.
  • Efficiency ratios: Assess how well the firm manages its current and non-current assets and liabilities in terms of their efficient management.
  • Liquidity ratios: Assess the ability of the firm to manage working capital and its ability to pay its short-term debts without running into cash flow and liquidity problems.
  • Gearing ratios: Assess the long-term capital structure of the business in terms of the relative quantities of debt and equity capital.
  • Investor ratios: Assess the performance of the business in terms of returns for shareholders.

  Profitability Ratios

  For most businesses, especially limited companies which have one eye on shareholder satisfaction, the profit earned for a period is the key indicator of business success. However, as we saw in the introductory section to this chapter, the size of the profit does not always provide very useful information about overall performance unless we are furnished with more information about the business. Therefore the Profitability Ratios are designed to provide more insight into assessing whether the profit earned is an indicator of success. The following are commonly used Profitability Ratios.

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• 

  eBook - ePub

  Accounting for Non-Accountants

  • David Horner(Author)
  • 2020(Publication Date)
  • Kogan Page

    (Publisher)

  Profit and profitability are not the same thing. Profit represents an absolute figure which is, broadly speaking, revenue less expenses. Profitability is concerned with looking at the profits earned in relation to some other variable such as sales or capital. Analysing profitability involves looking at how the firm is generating profit, or its potential to generate future profits.

  We can use accounting ratios to help us assess how well a firm is performing. An accounting ratio is the comparison of two or more pieces of financial data which, once combined, aim to give much more meaningful and useful information about business performance.

  In this chapter we will consider what each ratio indicates in terms of assessing business performance and how it is calculated.

  Types of accounting ratio

  There are many different accounting ratios which can be calculated and they all attempt to enable us to interpret business performance. The different ratios can be categorized according to what particular aspect of business performance they are designed to assess. Although there is no definitive method of classifying ratios, the following groupings are fairly typical:

  • Profitability Ratios: Assess measures of profits in relation to sales, capital and other financial variables.
  • Efficiency ratios: Assess how well the firm manages its current and non-current assets and liabilities in terms of their efficient management.
  • Liquidity ratios: Assess the ability to pay its short-term debts without running into cash flow difficulties.
  • Gearing ratios: Assess the long-term capital structure of the business in terms of the relative quantities of debt and equity capital.
  • Investor ratios: Assess the performance of the business in terms of returns for shareholders.

  Profitability Ratios

  For most businesses, especially limited companies which have one eye on shareholder satisfaction, the profit earned for a period is the key indicator of business success. However, as we saw in the introductory section to this chapter, the size of the profit does not always provide very useful information about overall performance unless we are furnished with more information about the business. Therefore the Profitability Ratios are designed to provide more insight into assessing whether the profit earned is an indicator of success. The following are commonly used Profitability Ratios.

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  eBook - ePub

  Business Essentials for Utility Engineers

  • Richard E. Brown(Author)
  • 2017(Publication Date)
  • CRC Press

    (Publisher)

  When going through the definitions of financial ratios, it is important to remember that usage in the industry is not always consistent. For example, some sources define the ratio “return on sales” as operating income divided by sales. Others define it as pretax income (IBT) divided by sales. Still others define it as net income divided by sales. To avoid confusion, the remainder of this chapter only provides the most frequently used definition for each financial ratio. When actually examining and using financial ratios, the reader is encouraged to always verify the precise definitions that are being used.

  To help give the reader a better feel for financial ratios, beyond definitions, typical ratio values are provided. Most are based on 2007 financial statements for all US publicly traded electric utilities and combined electric and gas utilities. The exceptions are market ratios, which are based on traded market values as of January 2009. These data sets are used since they are large and publicly available.

  6.1 Profitability RatioS

  Profitability Ratios reflect how much money a company is making compared to some measure of company size. There are many different Profitability Ratios using different measures of profit for the numerator and different size measures for the denominator. Some of the more common Profitability Ratios are now presented.

  Gross profit margin, often referred to as gross margin, is the average amount of profit made per sale only considering the direct cost of producing the goods and/or services. In the above equation, operating revenue is equivalent to sales. Sales (operating revenue) minus the cost of goods sold is called gross profit. If gross margin is negative, money is lost on each sale (on average). If gross margin is positive, the company still might not be profitable, but the positive gross margin can be used to pay for non-operational costs such as interest payments.

  In 2007, the average gross profit margin for publicly traded US energy utilities was 55%, which was identical to the 2006 values. This represents the difference between energy sales and the direct cost of energy, including fuel for electricity generation, purchased gas, and purchased wholesale electricity. Gross profit margin is high, indicating a high amount of incremental profit for additional energy sales. Of course, additional energy sales will eventually lead to the need for additional infrastructure and associated costs.

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  eBook - ePub

  Financial Intelligence for IT Professionals

  The Story of the Numbers

  • Julie Bonner(Author)
  • 2021(Publication Date)
  • CRC Press

    (Publisher)

  For our purposes, LogMeIn and Zoom have some similar product lines, so there is some comfort in the comparisons even though they are in different industries. If we were comparing Zoom to Boeing, it would be a lot more difficult for comparison purposes. There might not be a reason you have personally to compare their financial performance to each other.

  Topic 16: Profitability Ratios

  When examining the profit and loss statement for a company, you want to assess how profitable the company is and how that profitability is trending over time. Thus, Profitability Ratios are a specific way to assess how well a company uses its assets to generate profits.4

  Since you now understand that profit is not the same thing as cash, then you are looking for a consistency of earnings over time. For instance, it should feel different if a company is showing consistency and growth in their earnings versus a company with huge variations in their earnings.

  The gross profit margin is a Profitability Ratio that assesses gross profit on the profit and loss statement.5 Here is the gross profit margin formula:

  Gross Profit / Revenue

  Do not be surprised by terminology. In most cases, revenue is the first item on the profit and loss statement, but this can also be called Gross Sales, Net Sales, Sales, Net Revenue, or Gross Revenue. Plus, Gross Profit could be called Gross Margin. In addition, if you are looking up videos or other web content, you could find that the formula could be given to you as:

  Revenue − Cost of Goods Sold

  / Revenue

  Revenue minus cost of goods sold is the same thing as gross profit in the previous formula. In addition, if you use this rendition of the formula, the cost of goods sold can also be called cost of revenue.

  Gross Profit Margin

  The gross profit margin for Zoom and LogMeIn are examined here. From the 10-k reports, we have the following information for the two companies (all numbers are in thousands per the 10-k) (Figure 17 ):

  Figure 17 LOGM and ZM Revenue and Gross Profit Data

  Then we plug these numbers into the gross profit margin formula: Gross Profit/Revenue = Gross Profit Margin. Here are the results of the calculations for both companies (Figure 18

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  No longer available |Learn more

  QuickBooks 2018 All-in-One For Dummies

  • Stephen L. Nelson(Author)
  • 2017(Publication Date)
  • For Dummies

    (Publisher)

  Although this ratio may not seem useful at first blush, it can be very valuable. If you compare your gross margin percentage for this year with last year’s and see a decline, for example, you know that this isn’t good. Less gross margin means less money for operating expenses, interest expenses, and profits. On the other hand, if you compare your declining gross margin percentage with a competitor’s and see that your competitor’s gross margin percentage is declining even more rapidly than yours, well, you know that’s good. This comparison shows that you may actually be in pretty good shape: At least you aren’t hurting like your competitor. These are the sorts of insights that ratio analysis can provide. They enable you to put numbers from your income statement and balance sheet in context. This chapter steps through the formulas, provides examples, and gives useful guidelines for 16 common financial ratios. I group the ratios into four categories: liquidity ratios, leverage (or debt) ratios, activity ratios, and Profitability Ratios. Some Caveats about Ratio Analysis Before you go any further in using ratio analysis to draw conclusions, consider these two warnings about it: The ratios are only as good as your inputs. Obviously, the more accurate your QuickBooks accounting records are, the more accurate any ratios that you calculate by using the numbers from your QuickBooks financial statements will be. This makes sense, right? Garbage in, garbage out

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  No longer available |Learn more

  QuickBooks 2021 All-in-One For Dummies

  • Stephen L. Nelson(Author)
  • 2020(Publication Date)
  • For Dummies

    (Publisher)

  Although this ratio may not seem useful at first blush, it can be very valuable. If you compare your gross margin percentage for this year with last year’s and see a decline, for example, you know that this isn’t good. Less gross margin means less money for operating expenses, interest expenses, and profits. On the other hand, if you compare your declining gross margin percentage with a competitor’s and see that your competitor’s gross margin percentage is declining even more rapidly than yours … well, you know that’s good. This comparison shows that you may actually be in pretty good shape. At least you aren’t hurting, like your competitor. These are the sorts of insights that ratio analysis can provide. They enable you to put numbers from your income statement and balance sheet in context. This chapter steps through the formulas, provides examples, and gives useful guidelines for 16 common financial ratios. I group the ratios into four categories: liquidity, leverage (or debt), activity, and profitability. Some Caveats about Ratio Analysis Before you go any further in using ratio analysis to draw conclusions, consider these two warnings about it: The ratios are only as good as your inputs. Obviously, the more accurate your QuickBooks accounting records are, the more accurate any ratios that you calculate by using the numbers from your QuickBooks financial statements will be. This makes sense, right? Garbage in, garbage out

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  eBook - ePub

  QuickBooks 2024 All-in-One For Dummies

  • Stephen L. Nelson, Christian Block(Authors)
  • 2023(Publication Date)
  • For Dummies

    (Publisher)

  Although this ratio may not seem useful at first blush, it can be very valuable. If you compare your gross margin percentage for this year with last year’s and see a decline, for example, you know that this isn’t good. Less gross margin means less money for operating expenses, interest expenses, and profits. On the other hand, if you compare your declining gross margin percentage with a competitor’s and see that your competitor’s gross margin percentage is declining even more rapidly than yours … well, you know that’s good. This comparison shows that you may actually be in pretty good shape. At least you aren’t hurting, like your competitor. These are the sorts of insights that ratio analysis can provide. They enable you to put numbers from your income statement and balance sheet in context. This chapter steps through the formulas, provides examples, and gives useful guidelines for 16 common financial ratios. I group the ratios into four categories: liquidity, leverage (or debt), activity, and profitability. Uncovering Some Caveats about Ratio Analysis Before you go any further in using ratio analysis to draw conclusions, consider these two warnings about it: The ratios are only as good as your inputs. Obviously, the more accurate your QuickBooks accounting records are, the more accurate any ratios that you calculate by using the numbers from your QuickBooks financial statements will be. This makes sense, right? Garbage in, garbage out

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  eBook - ePub

  The Bank Credit Analysis Handbook

  A Guide for Analysts, Bankers and Investors

  • Jonathan Golin, Philippe Delhaise(Authors)
  • 2013(Publication Date)
  • Wiley

    (Publisher)

  Margin-Type Ratios

  Margin-type ratios show the profitability of a particular line of business, essentially asking the question: How profitable on its own is this business line?

  This category of ratios is similar in structure to return-type ratios, but differs in that rather than taking into account an institution’s entire stream of operating income, margin-type ratios focus on a single component of the earnings stream corresponding to a type of activity.

  As mentioned, all bank business activities fall under either one of two groups corresponding to a bank’s two principal revenue streams: those that mainly generate interest revenue, and those that do not. Because it is easier to compute, it is not surprising that the most common margin-type ratio for banks is that which measures, on an average—and therefore approximate—basis, its net interest income per unit of earning asset. This is the function of a bank’s net interest margin , which is what a bank gets out of those assets. It is defined as net interest income divided by average earning assets.14

  Cost-Efficiency Ratios

  Finally, a third type of performance ratio looks at the cost side of the ledger. The two most common cost efficiency ratios are the cost-income ratio and the cost-asset ratio. Both measure a bank’s operating expenses—usually defined as noninterest expense other than tax and loan loss provisions—as the numerator of a fraction in which either preprovision income or (average) assets function as the denominator.

  1. The cost-income ratio reflects the degree to which a bank’s overheads are adversely affecting its ability to generate profits.

  2. The cost-asset ratio , also called cost margin , measures overheads as a percentage of total assets, a denominator that is less volatile than net income and therefore a more stable indicator of a bank’s relative cost base.

  Averaging the Denominator

  In practice, there are variations of these basic ratios that are used to analyze a bank’s performance. Nearly all of these variant indicators, however, are based on the five principal formulas. Although any of these five simple ratios are perfectly usable to gauge the profitability of the bank relative to its past performance and to other banks, in practice modifications are customary. By making these adjustments, these basic ratios can be adapted to answer the questions that are more truly relevant to the credit analyst’s objective.

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  eBook - ePub

  The Entrepreneur's Guide to Financial Statements

  • David Worrell(Author)
  • 2014(Publication Date)
  • Praeger

    (Publisher)

  Tip : Absorption costing is related to the concept of breakeven gross margin, which we calculated in Chapter 11. Absorption costing turns gross margin on its head: calculating what total price (and therefore margin) we must sell at in order to cover expenses (which is the definition of breakeven).

  In this chapter we’ve met several entrepreneurs who have used financial and operating ratios in various ways to solve real problems. Now let’s turn our attention to people outside the business—investors and bankers—and see how they might use these tools to answer their own unique set of questions.

  Summary

  • Financial ratios can be used to solve real-world problems and answer important business questions.

  • Financial ratio analysis can lead to better strategic decisions, but ratios by themselves do not create strategy—they merely help an owner or manager measure results and identify strengths and weaknesses of various business systems.

  • Calculating a single financial ratio is often not enough. Complex business problems often require using the results of one ratio to feed the inputs of another. • Ratios can expose problems and measure the impact of decisions. Tracking results over time is an important way to know whether business management decisions are helping or hindering the business. Passage contains an image

  13 How Bankers and Investors Evaluate a Business

  We’ve focused so far on evaluating our own business by using ratios. Business owners, however, are not the only ones interested in the health and prospects of their business. Outsiders, especially bankers and investors, will have an interest in evaluating our business, too. Whenever an entrepreneur seeks outside capital, it is useful to see the business from the view of a financier and be able to talk about our business in a way that they will understand and appreciate.

  Fundamentally, there are only two sources of financing: debt and equity. Debt includes any kind of loan, whether from a bank or any other lender. Equity includes any investment that includes stock or ownership of the company. Understandably, lenders and equity investors are looking for very different things: Lenders are looking for strong cash flow that will enable easy repayment of debt; an equity investor, meanwhile, may be much more interested in how fast the company can reach profitability—even if cash flow is poor.

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