4 ratios to measure profitability

The profitability of a company is an important metric because it can give a good indication to the company’s financial health. In this article we outline 4 ratios investors can use to evaluate the company’s profitability.

1.EBITDA margin

This ratio can identify the earnings of a company before interest, depreciation, and amortization as a percentage of the revenue. This will show the company’s operating profit in comparison to the revenue.

The formula for EBITDA Margin = Earnings before interest, depreciation and amortization / Revenue

EBITDA margins can be used to compare companies in the same industry and evaluate business earnings as a percentage of profits. A high EBITDA margin shows good profitability, the company is managing their expenses, and operating costs well. A low EBITDA indicates that the company does not operate as efficiently.

2.Net profit margin

Analysts who want to take into account all expenses when evaluating well a company is in generating total earnings for the company, can use the net profit margin ratio. The ratio takes into account total expenses including taxes, interests, and depreciation.

The formula = Net Profit / Revenue

This formula will calculate the net profit in proportion of the revenue of the company. A high net profit margin may indicate good management of all expenses. A low net profit margin may mean management is not effective with managing all its costs. It is a good ratio to use to evaluate how the company is in generating total earnings.

3.Return on equity

The return on equity (ROE) ratio is a tool that investors can use to compare companies from the same industry to identify which is the best out of the group. It essentially measures how effective management uses shareholders equity and turns it into income. The focus on this ratio is how well the shareholder equity is used.

The formula is net income/shareholders’ equity

The net income is the profit before dividends are paid to investors. The shareholder’s equity is calculated by taking assets minus liabilities.

High ROE may indicate the company is efficient at generating profits from shareholders equity.

4.Return on capital employed

The ratio of return on capital employed (ROCE) analyses more effectively how the company is using their capital to create profits. This ratio can demonstrate how efficient the company is run. That is, a high ROCE indicates that the company is well run which can be translate into higher profits for the company. This ratio does not just focus on the profitability on shareholders equity but the profitability of the company. A high ROCE may also mean the cash flow is solid. Investors should analyze ROCE for a few years and evaluate the level of consistency of the ROCE levels.

The formula for this is ROCE = EBIT/Capital Employed

EBIT is earnings before interest and taxes

Capital employed is total assets minus current liabilities

Lauren Hua is a private client adviser at Fairmont Equities.

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