Profitability Ratios

Profitability Ratios

Closely linked with income ratios are profitability ratios, which shed light upon the overall effectiveness of management regarding the returns generated on sales and investment.

Gross Profit on Net Sales

Does your average markup on goods normally cover your expenses, and therefore result in a profit?  This ratio will tell you.  If your gross profit rate is continually lower than your average margin, something is wrong!  Be on the lookout for downward trends in your gross profit rate.  This is a sign of future problems for your bottom line.

Note: This percentage rate can, and will, vary greatly from business to business, even those within the same industry.  Sales, location, size of operations, and intensity of competition are all factors that can affect the gross profit rate.

Net Operating Profit Ratios

Net Profit on Net Sales

This ratio provides a primary appraisal of net profits related to investment.  Once your basic expenses are covered, profits will rise disproportionately greater than sales above the break-even point of operations.

*EAT= earnings after taxes

Note: Sales expenses may be substituted out of profits for other costs to generate even more sales and profits.

Net Profit to Tangible Net Worth

This ratio acts as a complementary appraisal of net profits related to investment.  This ratio sizes up the ability of management to earn a return.

Net Operating Profit Rate Of Return

Your Net Operating Profit Rate of Return ratio is influenced by the methods of financing you utilize.  Notice that this ratio employs earnings before interest and taxes, not earnings after taxes.  Profits are taken after interest is paid to creditors.  A fallacy of omission occurs when creditors support total assets.

Note: If financial charges are great, compute a net operating profit rate of return instead of return on assets ratio.  This can provide an important means of comparison.

Management Rate Of Return

This profitability ratio compares operating income to operating assets, which are defined as the sum of tangible fixed assets and net working capital.

This rate, which you may calculate for your entire company or for each of its divisions or operations, determines whether you have made efficient use of your assets.  The percentage should be compared with a target rate of return that you have set for the business.

Earning Power Ratio

The Earning Power Ratio combines asset turnover with the net profit rate.  That is, Net Sales to Tangible Net Worth (see "Income Ratios") multiplied by Net Profit on Net Sales (see ratio above).   Earning power can be increased by heavier trading on assets, by decreasing costs, by lowering the break-even point, or by increasing sales faster than the accompanying rise in costs.

Note: Sales hold the key.