Profitability Ratios

A third group of ratios that we can use are profitability ratios. Profitability Ratios measure the level of earnings in comparison to a base, such as assets, sales, or capital. We have already reviewed two profitability ratios: Return on Equity and Profit Margin. Two other ratios we can use to measure profitability are Operating Income to Sales and Return on Assets.

Operating Income to Sales

Operating Income to Sales compares Earnings Before Interest and Taxes (EBIT) to Sales. By using EBIT, we place more emphasis on operating results and we more closely follow cashflow concepts. Operating Income to Sales is calculated as follows: EBIT / Net Sales

EXAMPLE - Net Sales are $ 460,000 and Earnings Before Interest and Taxes is $ 100,000. This gives us a return of 22% on sales, $ 100,000 / $ 460,000 = .22. For every $ 1.00 of sales, we generated $ .22 in Operating Income.

Return on Assets

Return on Assets measures the net income returned on each dollar of assets. This ratio measures overall profitability from our investment in assets. Higher rates of return are desirable. Return on Assets is calculated as follows:

Net Income / Average Total Assets

EXAMPLE - Net Income is $ 60,000 and average total assets for the year are $ 500,000. This gives us a 12% return on assets, $ 60,000 / $ 500.000 = .12.

Return on Assets is often modified to ensure accurate measurement of returns. For example, we may want to deduct out preferred dividends from Net Income or maybe we should include operating assets only and exclude intangibles, investments, and other assets not managed for an overall rate of return.