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Profitability ratio analysis represents mathematical formulas applied to a company’s financial statements. The results from these formulas help stakeholders determine how efficiently or effectively a business operates. Return on equity, return on assets, and profit margin are a few of the most common profitability ratios. These formulas measure both profit earned from selling goods and services and the financial returns made by investing money. Companies tend to use profitability ratio analysis as a benchmark tool to assess how well they operate compared to previous periods or a competitor.
A company’s profit margin is typically the most popular tool used in profitability ratio analysis. The basic formula is sales revenue less cost of goods sold divided by sales revenue. The result indicates what percent of sales a company can expect to remain after paying the inventory costs for all goods or services sold during a period. This remaining money helps the company pay for any expenses related to generating the sales revenue. Most companies use this formula on a monthly basis in most cases.
Return on assets measures net income against the total assets a company has in its operations. Net income is sales less cost of goods sold and total expenses. Total assets represent the book value for all items a company owns as listed on the balance sheet. The return on asset formula is net income divided by total assets. The percentage indicates how well a company uses owned assets to generate profits, with a higher percentage more favorable to the business.
A slightly different formula for profitability ratio analysis is the return on equity ratio. This formula divides net income — as computed earlier — by total stockholder’s equity. Stockholder’s equity represents the amount of external investment made into a business by investors. Companies use this ratio to assess how well they use these external funds to incur profit from their business operations. Again, a higher percentage indicates more efficient use of funds and better profitability for the business.
Companies must have a defined purpose for profitability ratio analysis. Used alone, these ratios are really quite meaningless as the data does not tell companies very much about their operations. A company may use ratios as goal-setting tools. For example, a company may strive to achieve a 25 percent profit margin on a certain line of goods. Constant assessment of these products using the profit margin formula can help the company determine if it is reaching its goal.
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