Profitability ratios: 12 ways to measure company performance

To a layman, a profitable business is generally defined as one that generates more revenue than expenses. However, For finance professionals, there are many ways to calculate company performance through the numerous profitability ratios..

ROI or ROA are some of the most well-known profitability ratios, but business efficiency analysis can be applied on the basis of a number of parameters and criteria, giving rise to complex acronyms such as RAROC, RORAC, ROTE, RORWA...

What are profitability ratios?

The profitability ratios are mathematical formulae that allow us to reveal how the organisation is doing financially, i.e. the efficiency with which the company has used resources to make a profit.

However, this economic calculation can be made on the basis of different items of the balance sheet or profit and loss account and integrate different elements in its analysis, The final result of the company's performance may vary significantly. For example, a business may be profitable - understood as receiving profits for an investment - if we analyse the expenses dedicated to producing the good or service with the income received, but it may suffer losses if we add personnel costs to the computation of the investment made, taxes, interest, bank interest, amortisation, fixed capital...

Hence the importance of to know what the different profitability ratios are and what they mean in order to get a reliable picture of efficiency of the company in all areas that will enable us to develop a expenditure control and operational strategy .

What are the most commonly used profitability ratios?

Among the formulas The following are the most important for this calculation:

• ROI (Return on Investment). This ratio indicates the company's return on assets, i.e. the efficiency of asset utilisation, and is obtained by dividing earnings before interest and taxes (EBITDA) by total assets.

ROI= Gross Profit / Total Assets

• ROE (Return on Equity). This financial profitability ratio is one of the most widely used in the business sector as it shows the net profit obtained compared to the shareholders' investment. It is calculated by dividing net profit (after tax) by shareholders' equity.

ROE= Net Profit / Own Assets

• ROTE (Return of Tangible Equity). Very similar to the previous one, with the difference that it excludes from capital those intangible elements, such as preference shares or goodwill.

ROTE= Total Profit / Tangible Equity

• ROA (Return of Assets).  It calculates the ratio of return to total assets of the company.

ROA= Net Profit / Total Assets

• RORWA (Return on Risk-weighted Assets). This is the risk-adjusted return that relates capital to risk-weighted assets.

RORWA= Net Profit / Risk Weighted Assets

• Net return on assets. It is based on the Dupont system and links the ability of assets to produce profits, regardless of how they have been financed.

Return on net assets= (Net income / Sales) * (Sales / Total assets)

• Gross margin. It approximates the profitability of sales versus cost of sales and highlights the company's ability to meet operating expenses and generate revenues.

Gross margin = (Sales - Cost of sales) / Sales

• Debt to Assets. It shows the level of financial autonomy of the company.

Debt to Assets = Total Liabilities / Total Assets

• Current liquidity. It is one of the most frequent measures of the organisation's ability to pay off its operations in the short term.

Current Liquidity= Current Assets / Current Liabilities

• Net profit on average equity. This is the return obtained by the shareholder based on the book value of equity, understood as paid-up capital plus reserves and retained earnings.

Net profit on equity = Net profit / Average equity

• Default ratio. In this case, the objective is to know the company's debtor ratio.

Non-performing loans ratio= Non-performing loans/ (total loan portfolio + guarantees + other contingent liabilities)

• Return on assets. A ratio that measures the return on a company's assets by establishing a relationship between net profits and the company's total assets.

Return on Assets = Net Profit / Total Assets