Question

Discuss the pros and cons of using the various measures of profitability to examine a company’s performance.

Answer 1

Discuss the pros and cons of using the various measures of profitability to examine a company’s performance.

Profitability is a key metric in business as companies need to know how much they make from their activities. A few different measures used by businesses include the income statement, gross margin ratio, and return on investment analysis. Each method is proper for measuring financial returns, although a company can only use one if it desires. Profitability is both an internal metric and a benchmark. High profits often indicate a strong ability to reinvest earnings and compete heavily for market share in the business environment.

The income statement represents all sales revenues, cost of goods sold, and expenses for a stated time period. The statement is part of standard accounting procedures and is usually a monthly report. There are two measures of profitability there, with both being important. The first is gross profit, which is sales revenue less cost of goods sold, and represents the amount of money left after paying for the costs related to inventory sold. Gross profit less expenses results in net income, which is the money left for reinvesting into the business.

Gross profit ratios are a similar profitability measure in comparison to the first metric from the income statement. The formula is slightly different here: sales revenue less cost of goods sold divided by sales revenue. This metric works best for determining the profitability on individual products or product lines as well as the overall gross profit ratio. It indicates what percent of every dollar goes to pay for inventory costs. Companies can use this measure to compare itself against other businesses in the industry.

Return on investment is a measurement that reviews the profitability for various projects in which a company engages. The classic formula here is investment gain less investment cost divided by investment cost. Companies can typically use this as a preproject profitability measurement as they look to find the most profitable projects among several options. In most cases, companies desire selection of the most profitable projects as these will add to the bottom line and not create a drag on company resources. Other profit measures are necessary to compare profits after the project is up and running.

Hybrid profit metrics or other profit measures may be more appropriate for a company. These may include time value of money measurements, the statement of cash flows, or return on equity ratios. In short, there is really no end to the methods available when measuring profit. The company must simply assess the formula against the need and select the appropriate profitability measure.

What Are Profitability Ratios?

Profitability ratios are a class of financial metrics that are used to assess a business's ability to generate earnings relative to its revenue, operating costs, balance sheet assets, and shareholders' equity over time, using data from a specific point in time.

What Do Profitability Ratios Tell You?

For most profitability ratios, having a higher value relative to a competitor's ratio or relative to the same ratio from a previous period indicates that the company is doing well. Ratios are most informative and useful when used to compare a subject company to other, similar companies, the company's own history, or average ratios for the company's industry as a whole.

For example, the gross profit margin is one of the most often-used profitably or margin ratios. Some industries experience seasonality in their operations, such as the retail industry. Retailers typically experience significantly higher revenues and earnings during the year-end holiday season. It would not be useful to compare a retailer's fourth-quarter gross profit margin with its first-quarter gross profit margin because it would not reveal directly comparable information. Comparing a retailer's fourth-quarter profit margin with its fourth-quarter profit margin from the same period a year before would be far more informative.

Examples of Profitability Ratios

Profitability ratios are the most popular metrics used in financial analysis, and they generally fall into two categories: margin ratios and return ratios. Margin ratios give insight, from several different angles, on a company's ability to turn sales into a profit.

Return ratios offer several different ways to examine how well a company generates a return for its shareholders. Some examples of profitability ratios are profit margin, return on assets (ROA) and return on equity (ROE).

Margin Ratios: Profit Margin

Different profit margins are used to measure a company's profitability at various cost levels, including gross margin, operating margin, pretax margin, and net profit margin. The margins shrink as layers of additional costs are taken into consideration, such as the cost of goods sold (COGS), operating and nonoperating expenses, and taxes paid.

Gross margin measures how much a company can mark up sales above COGS. Operating margin is the percentage of sales left after covering additional operating expenses. The pretax margin shows a company's profitability after further accounting for non-operating expenses. The net profit margin concerns a company's ability to generate earnings after taxes.

Return Ratios: Return on Assets

Profitability is assessed relative to costs and expenses, and it is analyzed in comparison to assets to see how effective a company is in deploying assets to generate sales and eventually profits. The use of the term "return" in the ROA ratio customarily refers to net profit or net income, the value of earnings from sales after all costs, expenses, and taxes.

The more assets a company has amassed, the more sales and potentially more profits the company may generate. As economies of scale help lower costs and improve margins, returns may grow at a faster rate than assets, ultimately increasing return on assets.

Return Ratios: Return on Equity

ROE is a ratio that concerns a company's equity holders the most since it measures their ability to earn a return on their equity investments. ROE may increase dramatically without any equity addition when it can simply benefit from a higher return helped by a larger asset base.

As a company increases its asset size and generates a better return with higher margins, equity holders can retain much of the return growth when additional assets are the result of debt use.