Use Profitability Ratios to Compare Investments

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Use Profitability Ratios to Compare Investments

Ratio analysis can provide valuable information about a company’s financial health. A financial ratio measures a company’s performance in a specific area. Ratios are derived from information on a corporation’s financial statements. A company’s statement of cash flow and balance sheet are available to investors. The ratio calculations are straightforward and require nothing more than a pencil and paper and rudimentary arithmetic. But a calculator would be helpful.

What they are

The profitability ratios include operating profit margin, net profit margin, return on assets, and return on equity.

The two profit margins

Profit margin measures how much a company earns relative to its sales. A company with a profit margin higher than its competitor’s is more efficient. There are two profit margin ratios: operating profit margin and net profit margin.

Operating profit margin measures the earnings before interest and taxes.

Operating Profit Margin

Net profit margin measures earnings after taxes.

Net Profit Margin

While it seems as though these both measure the same attribute, their results can be dramatically different due to the impact of interest and tax expenses. Similarly, the next two ratios appear to be similar, but they tell different stories. As an investor, you are interested in getting a return on your investment. So is a corporation.

Return on assets

Return on assets tells you how well management is performing on all the firm’s resources. However, it does not tell you how well they are performing for the stockholders.

Return on Assets

Return on equity

Return on equity measures how well management is doing for you, the investor, because it tells you how much in earnings it is getting for each of your invested dollars.

Return on Equity

Where can you find these ratios?

These ratios are easy to calculate, and the information is readily available in a company’s annual report. All you need do is review the income statement and balance sheet to come up with the data to plug into the formulas.