Keys to Profitability Ratios
Profitability ratios can be used to determine how efficient a business is at making money.
They are also useful in comparing the profitability of different businesses to one another.
In general higher profitability ratios mean a company has a stronger competitive advantage.
Return on Assets or ROA
Return on Assets is calculated as net income divided by total assets. It is one of the simplest and most effective profitability ratios. Assets are used to scale profits as every business has assets.
Return on Equity or ROE
Return on equity is calculated as net income divided by equity. It shows the percentage of profit a company can make on its equity every year. For some businesses, this is a good way to gauge how quickly a company can grow.
Return on Invested Capital or ROIC
Return on Invested Capital or ROIC is a profitability ratio to measure the percentage return that a company earns on invested capital. The ratio shows how efficiently a company is using the investors’ funds to generate income
The numerator in the formula is net operating profit after taxes (abbreviated as NOPAT). This does not include interest expense. The reason being that this ratio is looking to find profitability before payment to debt investors.
The denominator in the formula is invested capital. It is calculated as total assets less excess cash and non-interest bearing current liabilities. The reason excess cash is subtracted is because it is not being used in actively funding the business. Non-interest bearing current liabilities are subtracted because they are capital invested in the business by suppliers, not investors. This is basically ‘free capital’ and should not be included in the calculation. Accounts payable is a good example of non-interest bearing current liabilities.
Cash Return on Invested Capital or CROIC
CROIC is very similar to return on invested capital. The Cash Return On Invested Capital, or CROIC, measures how effectively a company uses its Invested Capital to generate Cash. It is calculated as Free Cash Flow divided by Invested Capital. Invested Capital = Total Equity + Short-term Debt + Leases + Long-term Debt.
The denominator in this ratio is exactly the same as the denominator in ROIC.
The difference is in the numerator. ROIC uses NOPAT, while CROIC uses free cash flow in the numerator. Free cash flow is a cash based metric and is therefore not subject to the many estimates that go into accrual based measures like earnings.
Gross Profitability Ratio
A business with a higher gross profitability ratio outperforms those with a lower ratio. A business that can earn high margins should have a strong competitive advantage in place to be able to resist market forces and charge such a high premium. Highly profitable businesses should make more money for shareholders than low profitability businesses, all other things being equal.
The basic components of the formula of gross profit ratio (GP ratio) are gross profit and net sales. Gross profit is equal to net sales minus cost of goods sold. Net sales are equal to total gross sales less returns inwards and discount allowed.
The gross profitability ratio is simply gross profits divided by assets. The higher the gross profitability ratio, the better. It is a quick way to compare the amount of gross profits a business can generate from its asset base.
The information about gross profit and net sales is available from income statement of the company.