6 Profitability Ratios You Should Know

Summary

In this video, James walks viewers through six essential profitability ratios using a fictional company, Edison, which manufactures electric cars. He covers Return on Assets (ROA), Return on Equity (ROE), Return on Capital Employed (ROCE), and three margin ratios: Net Profit Margin, Operating Profit Margin (OPM), and Gross Profit Margin. Each ratio is explained with clear calculations based on Edison's financial data, providing practical insights into how these ratios assess a company’s financial health and efficiency. The video is an excellent guide for understanding how to interpret key profitability metrics in business analysis.

Takeaways

• 😀 Return on Assets (ROA) is a profitability ratio that measures how efficiently a company uses its assets to generate profit. It is calculated by dividing net profit by total assets.
• 😀 A high ROA percentage indicates that a business is efficiently using its assets to generate profits, with a higher percentage being better.
• 😀 Return on Equity (ROE) measures the return on the money invested by the owners of the business. It is calculated by dividing net profit by total equity.
• 😀 A high ROE is desirable, but it could indicate that a company is highly leveraged, which introduces financial risk.
• 😀 Return on Capital Employed (ROCE) is calculated by dividing operating profit (EBIT) by capital employed, which includes owner’s equity and long-term debt.
• 😀 A higher ROCE indicates that a business is using its capital efficiently to generate profit.
• 😀 Net Profit Margin is calculated by dividing net profit by total revenue, and it indicates the percentage of revenue that is retained as profit after all expenses.
• 😀 Operating Profit Margin focuses on operational efficiency and is calculated by dividing operating profit (EBIT) by revenue, excluding interest and tax expenses.
• 😀 Gross Profit Margin is the ratio of gross profit to revenue and reflects how efficiently a company produces and sells its products before accounting for operating expenses.
• 😀 Understanding these profitability ratios (ROA, ROE, ROCE, Net Profit Margin, Operating Profit Margin, and Gross Profit Margin) helps assess a company's financial health and efficiency.

Q & A

What is Return on Assets (ROA) and how is it calculated?

Return on Assets (ROA) is a profitability ratio that measures how efficiently a company uses its assets to generate profit. It is calculated by dividing net profit by total assets. In the case of Edison, ROA is 12.5%, calculated as $10 billion net profit divided by $80 billion in total assets.

Why is a higher Return on Assets (ROA) considered better?

A higher ROA indicates that the company is using its assets more efficiently to generate profit. This means the business is able to produce more profit with the same amount of assets, which is generally a sign of better operational efficiency.

What is Return on Equity (ROE) and how do you calculate it?

Return on Equity (ROE) is a profitability ratio that measures how effectively a company uses its equity (investors' funds) to generate profit. It is calculated by dividing net profit by total equity. Edison’s ROE is 20%, calculated as $10 billion net profit divided by $50 billion equity.

What does a high Return on Equity (ROE) tell you about a company?

A high ROE indicates that a company is generating a significant profit relative to its equity, which is generally a positive sign for investors. However, it could also indicate that the company is highly leveraged, meaning it has taken on more debt to increase its profits, which could present financial risks.

What is Return on Capital Employed (ROCE) and how is it calculated?

Return on Capital Employed (ROCE) is a profitability ratio that measures a company’s ability to generate profit from its capital. It is calculated by dividing operating profit (EBIT) by capital employed. For Edison, ROCE is 21.76%, calculated as $13.6 billion operating profit divided by $62.5 billion capital employed.

How is capital employed calculated in Return on Capital Employed (ROCE)?

Capital employed is calculated by subtracting current liabilities from total assets. In Edison’s case, total assets are $80 billion, and current liabilities are $17.5 billion, which gives a capital employed of $62.5 billion.

What does Return on Capital Employed (ROCE) measure and why is it important?

ROCE measures how efficiently a company uses its capital (equity plus long-term debt) to generate operating profits. A high ROCE indicates that the company is using its capital efficiently to generate profits, making it an important indicator for investors and analysts.

What is Net Profit Margin and how is it calculated?

Net Profit Margin is a profitability ratio that shows the percentage of revenue that remains as profit after all expenses. It is calculated by dividing net profit by revenue. Edison’s Net Profit Margin is 12.5%, calculated as $10 billion net profit divided by $80 billion revenue.

Why is Net Profit Margin an important profitability ratio?

Net Profit Margin is important because it reflects the overall profitability of a company, considering all costs including cost of sales, operating expenses, taxes, and interest. A higher margin means the company keeps more of each dollar of revenue as profit, indicating better overall financial health.

How is Operating Profit Margin different from Net Profit Margin?

Operating Profit Margin (OPM) focuses on a company’s core operational efficiency, excluding interest and tax expenses. It is calculated by dividing operating profit (EBIT) by revenue. Unlike Net Profit Margin, which includes all expenses, OPM focuses only on operational costs, making it useful for comparing companies with different financing structures.

What is Gross Profit Margin and how is it calculated?

Gross Profit Margin is a profitability ratio that measures how efficiently a company produces its goods or services. It is calculated by dividing gross profit (revenue minus cost of sales) by revenue. Edison’s Gross Profit Margin is 25%, calculated as $20 billion gross profit divided by $80 billion revenue.

How can a company improve its Gross Profit Margin?

A company can improve its Gross Profit Margin by increasing the price of its products, reducing the cost of production, or changing the sales mix to focus on higher-margin products. This ratio is an important indicator of production efficiency.

What are the key differences between the six profitability ratios discussed?

The six profitability ratios each measure different aspects of a company’s profitability: ROA measures asset efficiency, ROE assesses equity efficiency, ROCE evaluates capital efficiency, Net Profit Margin shows overall profitability after all expenses, Operating Profit Margin focuses on operational efficiency, and Gross Profit Margin measures efficiency in production costs relative to revenue.