Understanding Profitability Ratios in Bookkeeping - dummies

Understanding Profitability Ratios in Bookkeeping

By Stephen L. Nelson

The profitability ratios analyze a firm’s profitability. In a sense, these profitability ratios are the most important ratios that you can calculate. They typically provide terribly useful insights into how profitable a firm is and why.

Gross margin percentage

Also known as the gross profit margin ratio, the gross margin percentage shows how much a firm has left over after paying its cost of goods sold. The gross margin is what pays the operating expenses, financing expenses (interest), and, of course, the profits.

The gross margin percentage ratio uses the following formula:

gross margin/sales

No guideline exists for what a gross margin percentage should be. Some firms enjoy very high gross margins. Other firms make good money even though the gross margin percentages are very low. In general, of course, the higher the gross margin percentage, the better.

Net operating margin percentage

You calculate the net operating margin percentage by using this formula:

operating income/sales

In the case of a business with an operating income of $60,000 and sales of $150,000, this formula returns the value 0.4. A 0.4 operating margin percentage, which is equivalent to 40 percent, indicates that a firm’s operating income equals 40 percent of its sales.

No guideline exists for what a net operating margin percentage should be. You want your operating margin percentage to be close to or better than those of your competitors’ net operating margin percentages.

Profit margin percentage

The profit margin percentage works like the net operating margin percentage; it expresses the firm’s net income as a percentage of sales, as shown in the following formula:

net income/sales

Say, for example, the formula returns a financial ratio of 0.33. This indicates that the firm’s net income equals roughly 33 percent of its sales.

Return on assets

The return on assets shows the return that the firm delivers to stockholders and the interest that the firm pays to lenders as the percentage of the firm’s assets. Some businesses (banks, for example) use return on assets to evaluate the business’s profitability.

The actual formula is

(net income + interest)/total assets

No guideline exists for what a return on assets ratio should be. The main consideration is, predictably, that the return on assets must exceed the capital charges on the assets.

Capital charge just equals the sum of the minimum profit that shareholders require to invest their money in a firm and the interest charges that lenders require for the money that they’ve loaned to the firm.

Return on equity

The return on equity financial ratio expresses a firm’s net income as a percentage of its owner’s equity or shareholders’ equity (shareholder’s and owner’s equity are the same thing).

The formula, which is deceptively simple, is

net income/owner's equity

No guideline exists for what is and is not an acceptable return on equity. However, some useful observations about how you should interpret the return on equity ratio that you calculate are

  • The return on equity ratio that you calculate needs to be at least as good as you deserve. If you are investing money in your business, you deserve a return on that money. And that return needs to be reasonable compared with your other alternatives.

  • The return on equity ratio hints at the sustainable growth rate that your firm can manage. Sustainable growth is the growth rate that your business can sustain over a long period of time. If you don’t take money out of the business (other than your salary) and you reinvest the return on equity that the business generates, the return on equity ratio equals your sustainable growth.

Sustainable growth business makes intuitive sense to some people, but it just leads to head-scratching for other people. In case you’re in the head-scratching group, consider a couple more comments:

  • Growing sales and profits also requires growing your capital structure.

  • If you don’t grow owner’s equity as your business grows, watch out. If you don’t grow your owner’s equity at least as fast as your business grows, your debt percentage ratio skyrockets (perhaps) without you even realizing it.