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Profitability Ratios Explained

The document defines profitability as a company's ability to generate earnings and outlines various profitability ratios, including return on equity, return on assets, gross profit margin, operating profit margin, and net profit margin. It provides formulas for calculating these ratios and discusses their relevance in assessing a company's financial health. Additionally, it highlights factors that banks or suppliers consider when lending short-term credit and mentions different levels of measuring profit.

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Justine Timtim Gomez
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12 views18 pages

Profitability Ratios Explained

The document defines profitability as a company's ability to generate earnings and outlines various profitability ratios, including return on equity, return on assets, gross profit margin, operating profit margin, and net profit margin. It provides formulas for calculating these ratios and discusses their relevance in assessing a company's financial health. Additionally, it highlights factors that banks or suppliers consider when lending short-term credit and mentions different levels of measuring profit.

Uploaded by

Justine Timtim Gomez
Copyright
© All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
Available Formats
Download as PPTX, PDF, TXT or read online on Scribd

PROFITABILIT

Y
*• Define profitability.
*• Solve profitability ratios
(return on equity, return on
assets, gross profit margin,
operating profit margin, net
profit margin).
*• Analyze, interpret, and
compare the profitability
ratios of sample companies
*Which ratio is more relevant
- quick ratio or current ratio?

* What other factors would a


bank or supplier look into in
deciding whether to lend
short-term credit?
*What do you
understand
with the
concept of
‘profit
*There are different
levels of measuring
profit:
• gross profit
• operating profit
• net profit or net
income
Give examples of businesses
which they think are very
profitable and examples of
businesses that they think are
not profitable.
Why do you think businesses
have different levels of
profitability
Profitability - refers to the
company’s ability to
generate earnings. It is one
of the most important goals
of businesses
Profitability ratios and thei
formulas
• These are the
1. return on equity, return on
assets
2. gross profit margin
3. operating profit margin
4. net profit margin
1. Return on equity
measures the amount of
net income earned in
relation to stockholders’
equity.

ROE (return on equity)


= Net income ÷ Stockholders’
In return on equity
- stockholder’s equity
should include all of its
components including
retained earnings.
2. Return on assets
measures the ability of a
company to generate
income out of its
resources/assets.
ROA (return on asset)
= Operating income ÷ Total
asset
In computing ROE and ROA, some
authors would prefer that the average
stockholder’s equity and average total
assets be used in the computation. The
idea is that since net income is earned
over the year, average equity and asset
balances should be used. A simple way
to compute for the average is just to
add the beginning and ending balances
then divide the sum by two. For ease,
you may just use ending balances in
computing the ratios.
Note also that some
authors use net income,
instead of operating income
as the numerator for ROA.
Some use net income plus
interest expense multiplied
by (1-tax rate) in the
numerator. The idea is to be
consistent in the application
3. Gross profit margin shows how
many pesos of gross profit is
earned for every peso of sale. It
provides information regarding the
ability of a company to cover its
manufacturing cost from its sales.
Remember that gross profit is just
sales less cost of goods or cost of
services.
Gross profit margin
= Gross profit ÷ Sales
4. Operating profit margin shows
how many pesos of operating
profit is earned for every peso of
sale. It measures the amount of
income generated from the core
business of a company.

Operating profit margin


= Operating income ÷ Sale
5. Net profit margin
measures how much net
profit a company generates
for every peso of sales or
revenues that it generates.
Net profit margin
= Net income ÷ Sale
*Sales Revenue P 2,000,000.00
*Cost of Sales/Service (1,300,000.00)
*Gross Profit 700,000.00
*Operating Expenes (199,000.00)
*Operating Profit 501,000.00
*Other Income 5,000.00
*Other Expenses (2,800.00)
*Net Income before Tax 503,200.00
*Income Tax (150,960.00)
*Net Income after Tax P 352,240.00
======================

* Sample Company Statement of Financial Performance for


the Year Ended December 31, 2014

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