How to Make Sense of a Company's Profitability Ratios
When getting to grips with interpreting a company report, you can test a company’s stock market reputation and money-making prowess using the following important formulas.
Price/earnings ratio compares the price of a share to earnings per share. A ratio of 10 means that for every £1 in company earnings per share, people are willing to pay £10 per share to buy shares in the company.
Price/earnings ratio = Share price Earnings per share
Dividend cover shows the number of times profits ‘cover’ the dividend. So, if profits were 100 and the dividend payment was 25 then dividend cover would be 4 times. Use it to determine whether a company is paying out earnings as opposed to retaining them in the business to fund growth. You can also see how likely it is that the company will be able to maintain its dividend strategy in the future.
Dividend cover = (Earnings per share) (Annual dividends per share)
Return on sales tests how efficiently a company is running its operations by measuring the profit produced per pound of sales.
Return on sales = Profit before taxation 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 = Profit for the year Total assets
Return on equity measures how well a company earned money for its investors.
Return on equity = Profit for the year 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 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 Sales or revenues
Accounting Glossary
accounting equation
The equation Assets = Liabilities + Equity, which demonstrates the two-sided nature of accounting and is useful for explaining the concept of double-entry accounting (or double-entry bookkeeping).
Accounting Glossary
accounting period
The time period for which financial information is being tracked in a business, such as monthly, quarterly, or annually.
Accounting Glossary
accounts receivable
An account that records the amounts that customers owe to a business.
Accounting Glossary
adjusting entry
A correction made to a bookkeeping account that adjusts for accounting errors or other necessary changes at the end of the accounting period.
Accounting Glossary
cash flows
Used to describe the source or sources of cash or how cash is used.
Accounting Glossary
Chart of Accounts
A list of all the accounts used by a business, including what types of transactions go into each account.
Accounting Glossary
debit
An accounting entry that increases an asset or expense account, and decreases a liability or income account.
Accounting Glossary
dividends
A portion of a company’s profits paid by share of common stock on a quarterly or annual basis.
Accounting Glossary
FASB
Financial Accounting Standards Board. FASB is the highest-ranking authority in the private (non-government) sector of the U.S. for making pronouncements on GAAP and for keeping accounting standards up-to-date.
Accounting Glossary
Federal Unemployment Tax
In the U.S., the fund that used to be known simply as Unemployment. Employers contribute to the fund, and states also collect taxes to fill their unemployment fund reserves. (The acronym FUTA means Federal Unemployment Tax Act.)
Accounting Glossary
fidelity bonds
A type of insurance — typically carried by employers for their employees — that helps guard against theft and reduce the risk of loss.
Accounting Glossary
FIFO
First-in, first-out. A method for costs of goods sold in which a business charges out product costs to cost of goods sold expense in the chronological order in which the goods were acquired.
Accounting Glossary
fungible
Describes a product that is interchangeable and virtually indistinguishable from another product.
Accounting Glossary
General Ledger
A summary of all of a business’s accounts and transactions.
Accounting Glossary
IASB
International Accounting Standards Board. The IASB (based in London) is the main authoritative accounting standards setter outside the U.S.
Accounting Glossary
Journals
The location in which bookkeepers keep records (in chronological order) of daily company transactions.
Accounting Glossary
LIFO
Last-in, first-out. A method for costs of goods sold that selects the last item you purchased first, and then works backward until you have the total cost for the total number of units sold during the period.
Accounting Glossary
LLP
Limited liability partnership. A legal structure that state laws offer to qualified professionals in which all the partners have limited liability.
Accounting Glossary
PC
Professional corporation. A legal structure that state laws offer to qualified professionals who otherwise would have to operate as an unlimited partnership liability.
Accounting Glossary
petty cash
A cash account that businesses keep on hand for unexpected expenses.
Accounting Glossary
revenue
Monies that are collected in the process of selling a company’s goods and services.
Accounting Glossary
salvage value
The amount that an asset is worth after it has been fully depreciated.
Accounting Glossary
statement of cash flows
A financial statement that summarizes a business’s cash inflows and outflows during an accounting period.
Accounting Glossary
transactions
Economic exchanges between a business or other entity and the parties with which the entity interacts and makes deals.
Accounting Glossary
worker’s compensation insurance
A type of insurance carried by employers that covers its employees in case they are injured on the job.
