Friday, May 22, 2009

Financial Ratios, pt 4 - Profitability Ratios

[ Financial Ratios, Part: 1 - 2 - 3 - 4 ]

Profitability ratios are probably the most universally understood ratio because of their direct impact on the bottom line as well as they encompass the idea of adding and creating value (the foundation of the capitalist structure). They describe the financial efficiency of an organization as well as provide a basis for valuation ratios such as PE ratios.

Return on Sales
Return on sales margins use revenue in the denominator. By looking at the operations process, company management can determine their profitability at different stages.

Gross Profit Margin = Gross profit / revenue
Net Profit Margin = Net income / Revenue

Return on Investment
Return on Assets (ROA) = Net Income / Average Total Assets
Return on Equity (ROE) = Net Income / Average Total Equity

The two major components of DuPont Analysis, these two ratios summarize some of the most fundamentally important concepts in investing. How much have I put in, and how much am I getting out? Higher ROAs and ROEs are the target of any good security. The only downside to extremely high ROAs or ROEs is that the earnings are usually volatile (risk. Or in other words, something that looks too good to be true, usually is).

[ Financial Ratios, Part: 1 - 2 - 3 - 4 ]

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