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What is a profitability ratio? How are they calculated? What do they mean?

The analysis of a company’s earnings tells the investor how well management is using the company’s resources. Gross profit margin, operating profit margin and net profit margin ratios are useful for internal trend lines and external comparisons; especially in industries such as food products and cosmetics where turnover is high and competition severe. The gross profit margin is an indication of management’s efficiency in turning over the company’s goods at a profit. It shows the company’s rate of profit after allowing for the cost of goods sold.

Operating profit margin is a more stringent measure of the company’s ability to manage its resources as it also takes into account the selling, general and administrative expenses incurred in producing earnings. One advantage is that it allows profit margin comparison between companies which do not show “cost of goods sold” as a separate figure and for which, consequently, gross profit margin cannot be calculated. (In computing this ratio for companies subject to excise taxes, e.g. tobacco companies, it is important that the net sales figure used in the calculation is “net sales after excise taxes”.) Net sales – (cost of goods sold + Selling, administrative and general expenses)/Net sales x 100 Net profit margin is an important indicator showing how efficiently the company is managed after taking into account both expenses and taxes. This ratio is the end result for the period. It effectively sums up in a single figure management’s ability to run the business. To be comparable from company to company and year to year, net profit must be shown before minority interest (part of subsidiary owned by other company) has been deducted and equity income added, since not all companies have these items. The sales figure used in this calculation should be net of excise taxes. Net earnings (before extraordinary items) – equity income + minority interest in earnings of subsidiary companies/Net Sales x 100 Pre-tax return on invested capital correlates income with the invested capital responsible for producing it, without reference to whether creditors or owners provided the capital. In other words, this ratio shows how well management has employed the assets at its disposal. Net earnings (before extraordinary items) + income taxes + total interest charges/Invested capital x 100 Net (or after-tax) return on invested capital is the difference between this ratio and the previous one are that income tax is not included in the numerator in this case, and total interest charges after tax, instead of total interest charges, are added to net earnings (before extraordinary items i.e. non-reoccurring income). Net earnings (before extraordinary items) + total interest charges (after tax)/Invested capital x 100 Net (after-tax) return on common equity is comparable to the previous one since both ratios are calculated on an after-tax basis. This ratio is of prime importance to common shareholders since it reflects the profitability of their capital in the business. Since taxes are an expense of doing business, the pre-tax return ratio has limited value as a comparison. Likewise, the net return on common equity does not provide a good comparison because the proportion of equity from capitalization to capitalization varies. Therefore, net return on invested capital can be the best overall measure of company-to-company performance. Net earnings (before extraordinary items) - preferred dividend/Common equity x 100