Question

Focus on Papa John's profitability ratios. Profitability should be viewed from three different perspectives: Profitability in relation to sales, Profitability in relation to assets, andProfitability in relation to equity.

Profitability ratios are very important to investors. Companies often use these ratios when evaluating its managers. Please answer in paragraph form

Answer 1

Return on Assets

Return on assets (ROA), as the name suggests, shows the percentage of net earnings relative to the company’s total assets. The ROA ratio specifically reveals how much after-tax profit a company generates for every one dollar of assets it holds. It also measures the asset intensity of a business. The lower the profit per dollar of assets, the more asset-intensive a company is considered to be. Highly asset-intensive companies require big investments to purchase machinery and equipment in order to generate income. Examples of industries that are typically very asset-intensive include telecommunications services, car manufacturers, and railroads. Examples of less asset-intensive companies are advertising agencies and software companies.

Return on Equity

Return on equity (ROE) – expresses the percentage of net income relative to stockholders’ equity, or the rate of return on the money that equity investors have put into the business. The ROE ratio is one that is particularly watched by stock analysts and investors. A favorably high ROE ratio is often cited as a reason to purchase a company’s stock. Companies with a high return on equity are usually more capable of generating cash internally, and therefore less dependent on debt financing.

Corporate Finance Institute

Profitability Ratios

Measures of a company's earning power

Resources > Knowledge > Finance > Profitability Ratios

What are Profitability Ratios?

Profitability ratios are financial metrics used by analysts and investors to measure and evaluate the ability of a company to generate income (profit) relative to revenue, balance sheet assets, operating costs, and shareholders’ equity during a specific period of time. They show how well a company utilizes its assets to produce profit and value to shareholders.

A higher ratio or value is commonly sought-after by most companies, as this usually means the business is performing well by generating revenues, profits, and cash flow. The ratios are most useful when they are analyzed in comparison to similar companies or compared to previous periods.

The most commonly used profitability ratios are examined below.

[Profitability Ratios Examples]

What are the Different Types of Profitability Ratios?

There are various profitability ratios which are used by companies to provide useful insights into the financial well-being and performance of the business.

All of these ratios can be generalized into two categories, as followsllowing:

A. Margin ratios

Margin ratios represent the company’s ability to convert sales into profits at various degrees of measurement.

Examples are: gross profit margin, operating profit margin, net profit margin, cash flow margin, EBIT, EBITDA, EBITDAR, NOPAT, operating expense ratio, and overhead ratio.

B. Return ratios

Return ratios represent the company’s ability to generate returns to its shareholders.

Examples include return on assets, return on equity, cash return on assets, return on debt, return on retained earnings, return on revenue, risk-adjusted return, return on invested capital, and return on capital employed.

What are the Most Commonly Used Profitability Ratios and Their Significance?

Most companies refer to profitability ratios when analyzing business productivity, through comparing income to sales, assets, and equity.

Six of the most frequently used profitability ratios are:

Gross Profit Margin

Gross profit margin – compares gross profit to sales revenue. This shows how much a business is earning, taking into account the needed costs to produce its goods and services. A high gross profit margin ratio reflects a higher efficiency of core operations, meaning it can still cover operating expenses, fixed costs, dividends, and depreciation, while also providing net earnings to the business. On the other hand, a low profit margin indicates a high cost of goods sold, which can be attributed to adverse purchasing policies, low selling prices, low sales, stiff market competition, or wrong sales promotion policies.

Price ratios are used to get an idea of whether a stock's price is reasonable or not. They are easy to use and generally pretty intuitive, but do not forget this major caveat: Price ratios are "relative" metrics, meaning they are useful only when comparing one company's ratio to another company's ratio, a company's ratio to itself over time, or a company's ratio to a benchmark.

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