Profitability Ratios

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Profitability Ratios. By the time you're done with profitability ratios, you'll be able to understand how to calculate the ratios for profit margin, return on equity or ROE, return on assets or ROA, and return on investment or ROI. The profit margin ratio evaluates how much of each dollar of revenue your company keeps as earnings. Earnings means money remaining after you've paid expenses. The formula for calculating your profit margin ratio is to take your net income after taxes, which can be found on your income statement, and divide that by your gross revenue, also found on the income statement.

For example, if your net profit after taxes is $50,000 and your gross revenue is a $100,000, that means your profit revenue ratio is 50%, the same as $50,000 divided by a $100,000. That means for every dollar of sales, you keep 50¢ as profit. Your profit margin ratio is a valuable number to know when your company is being compared to others in the same industry. Firms in the same industry with better profit ratios might be doing a better job at controlling costs. Learning your profit margin ratio and comparing it to others in your industry can help you figure out how to raise yours if need be.

Let's look at an example of a profit margin ratio next. Understanding the profitability of your company is essential because it helps you discern which assets or activities are making money for you and which are causing you to lose money. The ability of your company to generate earnings known as profitability is also a vital factor that banks use to determine your credit worthiness and your ability to receive loans. Let's begin learning how you can use profitability ratios to evaluate your company's health. We have learned about a number of different ratios in this module.

Remember that profit margin evaluates how much of each dollar of revenue your company keeps as earnings. Return on equity, or ROE, evaluates how much money you've earned on the money you invested in your business. Return on assets, or ROA, is a percentage that tells you how much are your assets, such as cash, inventory, and accounts receivable, contributing to your earnings. Return on investment, or ROI, determines how much you profit from a specific investment, such as a new machine. As a business owner, it's common to want to know how much money you've earned on the money you invested in your business, and that's where the return on equity, or ROE, comes into play.

For example, if you initially invested $40,000 to open your bakery, you might wonder how much that $40,000 has earned after a while. To determine your return on equity, divide your earnings before tax by your average owner's equity. Your average owner's equity can be found by taking the average of your owner's equity from the beginning and end of a period. The owner's equity is found on the balance sheet. For example, if your equity was $40,000 at the start of year one and $70,000 at the end, you'd simply add those two numbers to get a total of $110,000 and divide it by two, the number of periods you're comparing, to get $55,000 in average owner's equity.

Now that you know your denominator in the equation, let's look to the income statement once again to find out your numerator, which is your earnings before tax. Since you must divide your earnings before tax by your average owner's equity to determine your ROE, you'd take $7,000 divided by $55,000 to learn that your return on equity, or ROE, is now 13%, which means you've earned that much on the money that you left in your company. This helps you determine if you're making a worthwhile investment in your business by comparing it to other industries. For instance, if you know that you could generally earn 10% by investing in the stock market, your 13% looks like a good investment because you're earning more than 10%. Let's calculate ROE together.

Your return on assets, or ROA, is a percentage that tells you how much your assets, such as cash, inventory, and accounts receivable, are contributing to your earnings. To calculate return on assets, or ROA, divide your earnings before tax by your average total assets. For example, if your bakery had earnings before tax that were equal to $5,000 as you discover from your income statement, You'd use $5,000 as your numerator. Now let's say your total assets were $10,000 at the start of year one and $20,000 at the end. Find the average by adding $10,000 and $20,000 to get a sum of $30,000 which, when divided by two, gives you a denominator of $15,000 which represents your average total assets.

Therefore, your return on assets would be 33%, which means that for every dollar in assets your company has, an additional 33¢ is generated. ROA will tell a business owner if the company could be making a better return by taking some of its assets and investing them elsewhere, such as stocks or bonds. One way to get a higher return on assets is to increase your profits and reduce your assets. For example, renting your store instead of buying it, or buying your store and renting it back to the company. Now that you've learned how to calculate ROA, let's try it on your own.

In order to calculate your return on investment or ROI, it's important to clearly understand what is the actual investment that you want to evaluate. If you're investing in a new venture, such as opening another location or purchasing a new machine, You want to determine whether it's worth making the investment based on the expected return it will offer. To do that, you need to be able to single out the specific gain from the investment, such as the profit from the new location. To determine your ROI, you'd take your gain from the investment minus your initial cost of the investment and divide that difference by your cost of the investment. For example, if you buy a new $30,000 donut machine that brings you $45,000 worth of donut sales, you take $45,000 minus $30,000 to get $15,000 and divide that by $30,000 to get a 50% ROI.

Not bad. That means every dollar you spent on that machine generates 50¢ worth of profit. That doughnut machine is really paying off and was a smart decision. Let's determine your own ROI next.