1. Profitability analysis
Now we will focus on Profitability ratios, which are derived mainly from the Income Statement.
2. Profitability ratios
Profitability ratios are used to measure the income success of a company during a given period. There are several ratios, but we will focus on three - profit margin, asset turnover, and return on assets.
These ratios tell us about a company's ability to earn income, which subsequently determines a company's ability to grow, take out loans and get investors.
3. Profit margin
The profit margin is the rate of return on sales and tells us the percentage of every dollar of sales that results in net income.
Recall that net income, also known as the bottom line, is the amount a company makes after deducting expenses and taxes. It is equivalent to Net Income divided by Net Sales. Put another way, your profit margin would be the percentage of money you made after expenses divided by your sales.
For example, in 2017, Larry's Automotive had Net Sales of $2,097,000 and Net Income of $263,800, which gives a Profit Margin of 12 point 6%. This tells us that 12 point 6% of each dollar of sales results in net income. The industry average is 10 point 5%, which tells us that Larry's Automotive is doing better than its peers.
4. Asset turnover
The asset turnover ratio measures how efficiently a company leverages assets to create sales.
The equation is Net Sales divided by average total assets.
Think about your cookie business. You own several ovens that cook hundreds of cookies in a short amount of time. You divide the value of your ovens by sales and see that the ovens have made your business more efficient.
Here we can see that in 2017 the asset turnover for Larry's Automotive was 1 point 2. This means that Larry's Automotive generated $1 and 20 cents for each dollar it invested in assets.
5. Return on assets (ROA)
Return on assets, or ROA, measures overall profitability in relation to total assets and is used to determine the efficient use of assets.
The equation is net income divided by Average Total Assets. For example we see that the ROA is 15 point 4% for Larry's Automotive.
This tells us that for every dollar that Larry's Automotive invested in assets it generated 15 point 4 cents of net income.
6. Let's practice!
Now it's time for you to practice with some exercises. Good luck!