5 Key Profitability Ratios to Measure Income
Profitability ratios describe a company's performance and enable investors to compare the net income of different companies. Net income, measured as the difference between a company's revenues and its expenses provides the dollar value of profits for a company. However, because every is a different size, it's only natural that larger companies usually have higher profits while smaller companies have lower profits. Ratios level the playing field, so that you can compare the profitability of different companies.The following list itemizes six of the most commonly used profitability ratios and explains how to interpret and analyze them.
1. Return on Assets
Return on assets (ROA) measures a company's profitability, taking into consideration the total value of its assets. To calculate ROA, divide the year's net income by average assets. Average assets equals the average of beginning assets and ending assets for the year.For example, take Starbucks' fiscal year ended September 30, 2012:Net income: $1,384,700,000;Assets, October 2, 2011: $7,360,400,000;Assets, September 30, 2012: $8,219,200,000;Average Assets = ($7,360,400,000 + $8,219,200,000)/2 = $7,789,800,000;ROA = $1,384,700,000 / $7,789,800,000 = 17.78%
2. Return on Equity
Return on equity (ROE) measures a company's profitability, considering its total stockholders' equity. To compute ROE, divide net income by average stockholders' equity. To calculate average stockholders' equity, take the average of beginning stockholders' equity for the year and ending stockholders' equity for the year.At Starbucks:Net income: $1,384,700,000;Stockholders' equity, October 2, 2011: $4,387,300,000;Stockholders' equity, September 30, 2012: $5,114,500,000;Average stockholders' equity = ($4,387,300,000 + $5,114,500,000)/2 = $4,750,900,000;ROE = $1,384,700,000 / $4,750,900,000 = 29.15%
3. Gross Profit Margin
Gross profit margin (GPM), also known as gross profit ratio, measures how much money, on average, a company earns from making or reselling goods. It takes into account only the cost of purchasing or making the product and excludes all other costs. To compute GPM, divide gross profit by net sales revenue.Starbucks:Net revenues: $13,299,500,000Cost of sales: $5,813,300,000Gross profit = Net revenues - cost of sales = $13,299,500 - $5,813,300,000 = $7,486,200,000;GPM = $7,486,200,000 / 13,299,500,000 = 56.29%
4. Return on Sales
Return on sales (ROS), also known as net profit margin (NPR), measures profitability earned on sales revenue. While GPM accounts for only the cost of making or buying products, ROS accounts for all of the company's expenses. To compute ROS, divide net income by net sales revenue.Starbucks:Net revenues: $13,299,500,000Net income: $1,384,700,000ROS = $1,384,700 / 13,299,500,000 = 10.41%
5. Earnings Per Share
Earnings Per Share (EPS) measures a company's net income, scaled down to each individual share of common stock. You don't need to calculate it because it is presented at the bottom of a company's income statement. Investors can use EPS to measure their own share of a company's net income. For example, if you own 100 common shares of a company that earned $5.00 EPS, then your stock holdings earned $500.00 worth of net income. Needless to say, you won't see any of this money until the company pays you a dividend.Starbucks reported earnings per share of $1.83 per share on the face of its income statement. This means that a 100-share investment in Starbucks yielded $183.00 worth of net income.
Investors and financial analysts use profitability ratios to compare different companies' net income. Different ratios measure net income with respect total assets, stockholders' equity, common stockholders' equity, sales, and the number of shares of common stock outstanding.