What Is a Profitability Ratio?

Financial managers and analysts can discern how profitable a company is based on profitability ratios. A company is profitable when its expenses and other costs associated with producing products or offering services for customers is lower than its related earnings and income. A company may not generate profit but be able to stay in business for some period. Many growth-oriented start-up companies initially run their business based on investors' capital before they earn any income or profit. However, a business without profit cannot sustain its business in the long run.

Gross Profit Rate

Eight major profitability ratios that measure a company's profitability. However, only four of them may be used for a privately held company. They are: profit margin, gross profit rate, return on assets and asset turnover. The remaining four ratios are: earnings per share, price-earnings ratio, payout and return on common stockholders' equity ratios. Profit margin ratio is net income divided by net sales, while gross profit rate is gross profit divided by net sales. Profit margin ratio determines the percentage of each dollar of sales that generates net income. Conversely, the gross profit rate indicates a company's ability to maintain a sufficient selling price above its cost of goods sold.

Return on Asset

Return on asset ratio measures the overall profitability of assets. In other words, it identifies how much of earned income is produced for each dollar asset. It is calculated by dividing net income by average total assets. Conversely, the asset turnover ratio is determined by dividing net sales by average total assets. The ratio measures how efficiently a company uses its assets to generate sales. These ratios may vary considerably among industries.

Earnings Per Share

Earnings per share and price-earnings ratios are among the most often used financial ratios by investors.

Earnings per share (EPS) measures the net income earned for each share of common stock. It is calculated by first subtracting net income by preferred stock dividends then dividing the result by average common shares outstanding. If a company does not have any preferred stocks, then simply divide net income by the average common shares outstanding. On the other hand, the price-earnings ratio (P-E) is determined by dividing stock price per share by earnings per share. This ratio which is used most often by investors is a projective measure of profitability. Put it differently, P-E ratio indicates investors' expectation of a company's future earnings and growth.

Payout and Return

Payout ratio measures the percentage of earnings distributed to stockholders in cash dividends. It's obtained by dividing cash dividends declared on common stock to net income. Growth-oriented companies have low payout ratios because they retain their earnings to reinvest in the business. However, the return on common stockholders' equity is calculated by subtracting net income by preferred stock dividends and dividing the result by net income. Naturally, if the company has not issued any preferred stocks, the corresponding value is zero in the formula.