Profits keep companies in business and investors pouring their money into the company. Company managers and investors review the profitability of the company regularly to determine how the company’s profits compare to competitors. The company considers other businesses in the same industry as competitors. Investors consider any businesses seeking their funds as competitors. Profitability ratios, such as the gross profit margin and the operating profit margin, provide a method of measuring and comparing profitability. Investors and managers use numbers from the income statement to calculate these ratios. The income statement subtracts the total expenses from the total revenues to calculate the net profit.
1. Retrieve the current year income statement. Read the first section of this statement. Locate the total revenues, or the total of the first section.
2. Locate the gross profit on the income statement. The cost of goods sold appears after the revenues. The gross profit follows the cost of goods sold.
3. Divide the gross profit by the total revenue. This calculates the gross profit margin.
4. Locate the operating profit on the income statement. The operating expenses appear after the gross profit. The operating profit follows the operating expense section.
5. Divide the operating profit by the total revenue. This calculates the operating profit margin.
- In addition to these ratios, investors and managers also calculate the earnings per share and the price earnings ratio to measure profitability. The earnings per share ratio divides the net income by the number of outstanding shares of stock. The price to earnings ratio divides the market price for one share of stock by the earnings per share.
- Calculate these ratios for several years in a row. Compare these ratios to determine if the current year’s profits represent the company’s true profitability or if the year was unusual.
- Consider all aspects of the company’s performance when making financial investment decisions. Profitability only looks at the money earned. Solvency and liquidity ratios allow managers and investors to consider other aspects of the business. Solvency ratios calculate the company’s ability to remain in business. Liquidity ratios calculate the company’s ability to access cash.
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