Calculating a Company’s Profitability Ratios
This calculator can be used to determine several profitability ratios of a business based on information appearing on the income statement. The calculator needs a total of eight inputs, including:
- The total revenues for the period being examined, sometimes referred to as sales
- The cost of goods sold as found on the company’s income statement
- Selling, General & Administrative expenses, sometimes abbreviated as SG&A
- The amount of depreciation and amortization in the period being examined
- The total of all other operating expenses
- Non-operating income
- The company’s interest expense
- Income taxes, which in the United States can include both federal and state-level taxes
The calculator then provides the user with three outputs:
- The three most common profitability ratios, including gross profit margin, operating margin, and net profit margin
What are Profitability Ratios?
Profitability ratios, and more specifically margin ratios, are metrics analysts use to assess the ability of a company to generate income relative to their sales or revenues. These ratios are useful when comparing the performance of a company relative to its peers. Specifically, profitability ratios measure management’s ability to efficiently control expenses when producing goods or providing a service. All the calculations performed by this tool utilize information found on the company’s income statement.
How are the Profitability Ratios Calculated?
As was the case with our liquidity ratios, all three of these metrics use the same value in the denominator – revenues. The factors that differ for each ratio is the value used in the numerator as demonstrated in the formulas shown below:
Gross Profit Margin = (Revenues – Cost of Goods Sold) / Revenues, where
- Revenues = The value of all the goods and / or services provided in a pre-defined period; and
- Cost of Goods Sold = All the costs directly attributed to producing the goods or services. Examples of these costs include raw materials, factory labor, parts used in production, and factory overheads
Operating Margin = Operating Income / Revenues, where
- Operating Income = Revenues – Cost of Goods Sold – SG&A – Depreciation / Amortization – Other Operating Expenses
Net Profit Margin = Operating Income – Interest Expense – Income Taxes
We have the same situation with the profitability ratios that we had with the liquidity ratios. Gross profit margin, as the name implies, it is a very rough measure of profits. Since gross profit margin only subtracts the cost of goods sold from revenues, it provides insight into how much money is left over after paying for those cost directly attributed to making a product or providing a service. The money left over can then be used to pay for other expenses.
Our next metric is operating margin, which not only reduces revenues by the cost of goods sold, but also SG&A, amortization and depreciation, and all other operating expenses. Operating margin provides insights into the profitability of the company after paying for all expenses associated with making a product or providing a service.
The last metric, net profit margin, not only reduces revenues by operating income, but it also includes interest expense and income taxes. By including interest expenses, we now have a more complete view of profitability that includes paying lenders interest owed on debt the company may have issued to fund operations. In addition, since this metric also includes income taxes, net profit margin tells us the percentage of sales revenues that are leftover to share with the owners of the company.
What are Considered “Good” Profitability Ratios?
Given how each of these ratios are calculated, we know gross profit margin will be greater than a company’s operating margin which will be greater than their net profit margin. We also know that higher percentages are more desirable. But what constitutes a good profitability ratio? Once again, the answer to this question takes us back to peer companies and benchmarking. Several statistical sources state the average profit margin across all industries is around 8%. But the average profit margin for food wholesalers is less than 1%. At the other extreme, the average profit margin of the semiconductor industry is over 25%. Therefore, it’s important for the analyst to compare the profitability ratios of companies in the same industry. That is why comparing margins of companies in various industries reveals nothing in terms of how well a company is being run.