## 4. Table of profitability financial ratios, formulas and interpretation

All profitability ratios which we discussed in this tutorial are summarized in the table below:

 PROFITABILITY RATIOS Measure the ability of a company to generate profit RATIO FORMULA APPLICABILITY Return on Sales (ROS) Operating Profit ÷ Total Sales Measures how much profit a company generates per dollar of sales. Important Notes! When evaluating and analyzing the return on sales, it is important to consider the following factors: ROS ratio varies from industry to industry. ROS calculations should be consistent in what profit indicator (e.g., operating profit before subtracting interest and taxes or after-tax income) is used. ROS ratio can be inflated and therefore can be a misleading measure of profitability if the profit data used in its calculation includes special allowances and extraordinary non-regular items. Return on Assets (ROA) Net Profit before Taxes ÷ Total Assets Measures how effectively a company utilizes assets available to generate profits. Important Notes! The following factors should be taken into account, when evaluating ROA ratio: Using net profit (instead of net profit before taxes) will normally decrease the ROA ratio. ROA ratio can be considered a measure of asset intensity. Normally, return on assets ratios are higher in low asset-intensive industries and lower in high asset-intensive industries. Investors are usually interested in companies with higher returns on assets within an industry. Return on Equity (ROE) Net Income (after Taxes) ÷ Average Shareholder's equity Measures how effectively a company employs resources provided by owners (i.e., shareholder’s equity) in generating earnings. Important Notes! The return on equity ratio can be a misleading measure of profitability in some circumstances: ROE ratio for smaller companies can show low returns even though such companies can be quite profitable. When comparing ROE ratios within the same industry, the effect of debt should also be taken into account. Return on Investment (ROI) (Gain from Investment – Cost of Investment) ÷ Cost of Investment Evaluates the profitability of an investment in relation to the invested capital. Important Notes! When evaluating the return on investment ratio, it is important to consider the following factors: What is the probability that expected returns and costs will be as forecasted? Quite often expectations about future returns (e.g., earnings of a company) don’t equal exactly what was anticipated. There are multiple ways to calculate the return on investment ratio. It is important to understand how a particular ratio was calculated when comparing it with other return on investment ratios. Return on Capital Employed (ROCE) Income before Taxes ÷ Capital Employed Measures how efficiency and profitably a business operates with the capital employed. Important Notes! One of the limitations of return on capital employed is the fact that it does not account for the depreciation and amortization of the capital employed. Because capital employed is in the denominator, a company with depreciated assets (e.g., an older company) may find its ROCE increase without an actual increase in profit. Earnings before Interest and Taxes (EBIT) Revenue – Cost of Goods Sold – Operating Expenses + Non-operating Income An indicator of a company’s profitability before interest and income tax expenses. Important Notes! If the company does not have non-operating income, EBIT is also called operating profit because it shows a company’s earnings from ordinary operations. EBITDA EBIT + Depreciation + Amortization An indicator of company’s profitability before interest, income tax expenses, depreciation and amortization. Important Notes! EBITDA is a non-GAAP (Generally Accepted Accounting Principles) measure of profitability. It can be a misleading measure of profitability in many circumstances, for example: EBITDA of a fixed asset intensive company may appear more attractive because significant depreciation related to fixed assets is excluded. EBITDA does not reflect a company’s ability to service all debts.
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