Calculation of Profitability Ratios
Interpretation of Profitability Ratios
Gross Profit Margin
Gross profit margin indicates the percentage of revenue available to cover operating and other expenses and to generate profit.
Operating Profit Margin
Operating profit is calculated as gross profit minus operating costs. So, an operating profit margin increasing faster than the gross profit margin can indicate improvements in controlling operating costs, such as administrative overheads. In contrast, a declining operating profit margin could be an indicator of deteriorating control over operating costs.
Pretax Margin
Pretax income (also called “earnings before tax” or EBT) is calculated as operating profit minus interest, and the pretax margin is the ratio of pretax income to revenue. The pretax margin reflects the effects on profitability of leverage and other (non-operating) income and expenses.
Net Profit Margin
Net profit, or net income, is calculated as revenue minus all expenses. Net income includes both recurring and non-recurring components. Generally, the net income used in calculating the net profit margin is adjusted for non-recurring items to offer a better view of a company’s potential future profitability.
ROA
ROA measures the return earned by a company on its assets. The higher the ratio, the more income is generated by a given level of assets. Most databases compute this ratio as follows:
An issue with this computation is that net income is the return to equity holders, whereas assets are financed by both equity holders and creditors. Interest expense (the return to creditors) has already been subtracted in the numerator. Some analysts, therefore, prefer to add back interest expense in the numerator. In such cases, interest must be adjusted for income taxes because net income is determined after taxes. With this adjustment, the ratio would be computed as follows:
Alternatively, some analysts elect to compute ROA on a pre-interest and pre-tax basis as follows:
Return on Invested Capital
Return on invested capital (ROIC) measures the after-tax profitability a company earns on all of the capital that it employs (short-term debt, long-term debt, and equity). As with operating ROA, returns are measured prior to deducting interest on debt capital (i.e., as operating income or EBIT).
ROE
ROE measures the return earned by a company on its equity capital, including minority equity, preferred equity, and common equity. As noted, return is measured as net income (i.e., interest on debt capital is not included in the return on equity capital). A variation of ROE is return on common equity, which measures the return earned by a company only on its common equity.
