Reading Financial Reports for Profitability Ratios - dummies

# Reading Financial Reports for Profitability Ratios

You read financial reports to get a sense of a company’s financial position and how viable it is in the marketplace. You can test a company’s money-making prowess using the following important formulas.

• Price/earnings ratio compares the price of a stock to its earnings. A ratio of 10 means that for every \$1 in company earnings per share, people are willing to pay \$10 per share to buy the stock.

Price/earnings ratio = Market value per share of stock divided by Earnings per share of stock

• Dividend payout ratio shows the amount of a company’s earnings that are paid out to investors. Use it to determine the actual cash return you get by buying and holding a share of stock.

Dividend payout ratio = Yearly dividend per share divided by Earnings per share

• Return on sales tests how efficiently a company is running its operations by measuring the profit produced per dollar of sales.

Return on sales = Net income before taxes divided by Sales

• Return on assets shows you how well a company uses its assets. A high return on assets usually means the company is managing its assets well.

Return on assets = Net income divided by Total assets

• Return on equity measures how well a company earns money for its investors.

Return on equity = Net income divided by Shareholders’ equity

• The gross margin gives you a picture of how much revenue is left after all the direct costs of producing and selling the product have been subtracted.

Gross margin = Gross profit divided by Net sales or revenues

• The operating margin looks at how well a company controls costs, factoring in any expenses not directly related to the production and sales of a particular product.

Operating margin = Operating profit divided by Net sales or revenues