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What Do We Know About The Profitability Ratio Analysis?

March 30, 2016 | Author: | Posted in Business

It is well known that the main goal of running a business is the generation of profits. The ability of an enterprise to generate profits is called profitability. Measuring and improving this ability is the biggest concern for the company’s owners since their revenue is being derived in the form of dividends. Firm’s profitability is also an object of interest for the external users, for example, creditors that are willing to estimate the company’s debt coverage sources.

Company’s profitability evaluation can be proceeded through analyzing its main financial statements, such as balance sheet and income statement. This process is called profitability ratio analysis, and it includes the calculation and interpretation of a set of indicators (ratios). Commonly, scientists divide profitability ratios into two groups: margins and returns. Key profitability margins include net profit margin, operating income margin, gross profit margin, etc. They all measure the ability of a firm to convert money received from sales into profits from different angles. As for the returns, the main ratios of this group are return on assets, return on investment, return on equity, etc. They show the company’s ability of returns generation for shareholders. More information on the profitability ratios, their computation formulas and interpretations can be found here.

Most of the above-mentioned ratios are closely connected since they reflect the same trends in the company performance. This can be used for effective analysis and decision making to improve the company’s performance. One of the most widely known cases that show the close relationship between different profitability ratios is DuPont analysis. It is named after DuPont Corporation, which was the first to start using this formula in the 1920s. It is breaking the return on equity computation into two stages: net profit margin and total asset turnover computation. This is being made in order to find out, which influence do these ratios have on the return on equity and to make some decisions, aimed at enhancing the positive drivers and minimization of the negative influence.

Profitability ratios calculated for one certain year do not give a complete insight into the company’s financial condition and, especially, performance. For more precise estimation it is important to calculate the same set of ratios for different periods and to browse their dynamics. Analyzing the fluctuations and detecting trends allows to predict possible development scenarios and take efficient measures in order to avoid negative financial results.

Considering everything said, profitability ratio analysis should be an object of a close attention of all the people related to the business, from the company’s owners and management to its existing and potential investors. All these users can apply the profitability analysis in their own needs to estimate the side of the company’s performance they are interested in. Performing the profitability ratio analysis is fast and simple with websites like Finstanon, which allow you to generate a detailed analytical report on your company, based on data from its financial statements.

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I am a master in finance and a co-founder of Finstanon, an online financial statement analysis tool.

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