Definition of 'Profitability Ratios'
Profitability ratios address a company, business, or enterprise’s ability to generate earnings in a specific period of time in light of expenses and costs. As such, profitability ratios represent a family of concepts such as return on equity, return on assets, and profit margin, that should be used together to draw sound conclusions about an investment opportunity.
TheStreet Explains ‘Profitability Ratios’
Profit margins are calculated by dividing net income by revenue; return on assets is calculated by dividing net income by total assets; return on equity is calculated by dividing net income by shareholder’s equity. Individually, these calculations represent cross-sections of what a company is capable of in terms of earning money for itself and earning money for investors. Together, as a group of profitability ratios, they represent a holistic picture of performance.
A company’s income statement will list gross profit, operating profit, pretax profit, and net profit. To assess that company’s historical profitability (in order to identify trends and intimate what it will do next), several years of past income statements are handy to have around. In comparing the profitability of individual companies relative to others in its industry, an understanding of industry factors will offer context for the shape of trends. For example, a political coup may be the reason that a mining company’s profits plummeted from one quarter to the next. Or, the changeover in an annual retail cycle—between November and December—may be the reason a clothier’s profits jumped significantly in a short period of time. In either case, the time period being analyzed will have an impact on any of the concepts that fall under the umbrella of profitability ratios.
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