Types of Profitability Ratios and Formulas
The different types of profitability ratios are helpful as they help a business or a company assess its financial performance in relation to its revenue, operating costs, balance sheet assets, equity, etc. As businesses operate, there is a need to assess their financial performances at the end of each accounting period. With this, they will be able to make informed financial decisions as required in order to maintain a favorable performance of the business. These profitability ratios are in place for this purpose. In this article, we see what profitability ratios are, their types, formulas, and examples.
What are profitability ratios?
Profitability ratios can be compared with efficiency ratios which take into consideration how well a company makes use of assets internally to generate income as opposed to after-cost profits.
For most profitability ratios, if a company has a higher value relative to its competitor’s ratio or relative to the same ratio from a previous period, is an indication that the company is doing well. Profitability ratios are most useful when they are compared to that of similar companies, the company’s own history, or average ratios from the company’s industry.
One of the most widely used profitability ratios is the gross profit ratio, which will be explained in detail under the types of profitability ratios. Gross profit is the difference between sales revenue and the costs of production or the cost of goods sold.
Some industries experience seasonality in their operations, for example, retailers typically experience revenues and earnings that are significantly higher during year-end holiday seasons. With this, it would not be of use to compare a retailer’s fourth-quarter profitability ratio with its first-quarter profitability ratio because they are not directly comparable. So comparing a retailer’s fourth-quarter profitability ratio with its fourth-quarter profitability ratio from the previous year would be more informative by far.
Profitability ratios are one of the most popular metrics in financial analysis as investors and analysts use them to assess how well a company is performing.
Types of profitability ratios
- Gross profit ratio
- Operating ratio
- Operating profit ratio
- Net profit ratio
- Return on capital employed
- Return on investment (ROI)
- Return on net worth/return on equity (ROE)
- Earnings per share
- Book value per share
- Dividend payout ratio
- Price-to-earnings ratio
- Return on assets ratio
The above-mentioned types of profitability ratios are explained below.
Gross profit ratio
The gross profit ratio is a type of profitability ratio that assesses the relationship between gross profit and net sales revenue. It is usually expressed as a percentage, also referred to as the gross profit margin. By comparing sales with the company’s gross profit, the gross profit ratio will give the users the ability to know the profit margin that the company is earning from the business activities such as trading and manufacturing. This metric determines how much a company makes more than the amount it has to pay for its operating expenses.
Investors and analysts use this financial metric to determine the efficiency of a business. This ratio can also be compared with the ratio of other years or with that of other firms to compare and assess the efficiency of the business. Companies seek a higher gross profit ratio because it leaves a higher margin to meet operating expenses as well as to create reserves.
Operating ratio
The operating ratio is a metric that is used to determine the efficiency of a company’s management in keeping operating costs low while simultaneously generating revenues or sales by comparing the total operating expenses to that of its net sales. In other words, the operating ratio is calculated to determine the cost of a company’s operation in relation to the revenue earned from the operations.
The operating ratio, in essence, is one of the many ways investment analysts a company’s performance. It bases on a company’s core business activities and it is used alongside return on assets and return on equity ratios to measure a company’s operational efficiency. In essence, the metric tracks the operating ratio over a period of time to identify trends in operational efficiency or inefficiency.
An increasingly high operating ratio is considered a negative sign because it is an indication that operating expenses are increasing in relation to sales or revenue. If the operating ratio is falling, on the other hand, it is an indication that expenses are decreasing or revenue is increasing, or some combination of both. With this, there is a need for a company to implement cost controls for the improvement of its margin if its operating ratio increases over time. So, we can say that the operating ratio establishes a relationship between operating costs and revenues generated from operations. Operating costs are the costs a business or a company incurs for its operating activities.
Operating profit ratio
The operating profit ratio is another type of profitability ratio that is used in determining the operating profit and net revenue that a company generates from its operations. It is usually expressed as a percentage. This metric is computed in order to determine the operational efficiency of a business. It helps a company to understand how to keep operational costs streamlined to be able to get better margins on its products while keeping sales prices competitive and still having the ability to cater to periodic discounts and offers. A business’s operational profitability is reflected in the operating profit ratio.
So, when this ratio increases, it is an indication that the business is improving its operational efficiency in managing its core production and delivery expenses. A high variance in the operating profit ratio typically indicates a risky business profile given that there is a constant fluctuation in earnings and sales to be so volatile. It is important to note that this profitability ratio cannot be used to compare companies that operate in separate industries. So, it is important for investors to look out for companies that have a relatively stable operating ratio because aside from providing an insight into its core production activities, it also provides an insight into the status of its sales and earnings.
Net profit ratio
The net profit ratio is the ratio of a company’s after-tax profits to its net sales. It gives information regarding the remaining profit after all costs of production, administration, and financing are deducted from sales, and income taxes recognized. In other words, the net profit ratio is a type of profitability ratio that shows the relationship between net sales and net profit after tax. Because of this, it is one of the best measures of a firm’s overall results, especially when it is combined with an evaluation of how well it is making use of its working capital. The measure is commonly reported on a trend line to judge business performance over time. The profitability ratio is also used to compare a business’s results with its competitors.
The net profit ratio helps investors to determine whether the management of a company is able to generate profit from the sales and how well it contains its operating costs and costs related to overhead. The higher this ratio is, the better it is for the business. In essence, an increase in the net profit ratio over the previous year shows that there is an improvement in operational efficiency.
Return on capital employed (ROCE)
The return on capital employed profitability ratio is a metric that is used to measure a company’s profitability and efficiency in relation to the use of its capital. It simply measures how good a business is at generating profits from the capital employed, that is the business’s efficiency in the use of capital.
The ROCE can be especially useful when it comes to comparing the performance of companies in sectors that are capital-intensive such as utilities and telecoms. This is because the metric considers debt and equity unlike others like the ROE which only assesses a company’s profitability in relation to shareholders’ equity. This helps in neutralizing financial performance for companies with significant debt. With this, a higher return on capital employed is an indication of stronger profitability across company comparisons.
Return on investment (ROI)
Return on investment, as the name implies, is a type of profitability ratio that is used to understand the profitability of an investment. It compares the amount paid for an investment to the amount earned to evaluate its efficiency. In essence, ROI helps one to understand how much profit or loss his investment has earned. Both investors make use of this metric in order to shape their financial decisions. So a higher return on investment is better.
Return on net worth/ return on equity
Return on net worth, also known as return on equity or return on shareholders’ funds, is a type of profitability ratio that measures a company’s ability to earn a return on its equity investments. The ratio can rise as a result of a higher net income being generated from a larger asset base funded with debt. A higher return on shareholders’ funds is an indication that the company is efficient in converting its equity financing into profits.
Earnings per share (EPS)
Earnings per share is a type of profitability ratio that evaluates the extent to which a company earns in relation to each outstanding share. In other words, the EPS is used to determine the value that is attached to each outstanding share of a company.
In exchange, the amount of profit that companies make and the number of shares they have listed can vary, so earnings per share give a per-capita way of evaluating a business. It is a way for analysts to compare companies to each other and see the one that has higher earning figures. So, a higher EPS indicates a greater value because investors will pay more for a company’s shares if they feel that the company generates higher profits in relation to its share price.
Book value per share
Book value per share is a financial ratio that measures a company’s book value on a per-share basis. In other words, it is the ratio of the book value of equity against the number of outstanding shares. It is one of the ways adopted in gauging the value of a stock. The book value per share, in simple terms, is the minimum value of a company’s equity weighing a firm’s book value on a per-share basis. So, a company’s net asset value or total equity is its book value. This is referred to as total shareholders’ equity because shareholders own public companies. With this, a company’s book value also includes every piece of equipment and property that the company owns, as well as inventory or cash in hand.
An increase in a company’s book value per share implies that the stock is considered more valuable and the stock price would increase. So, this is a way of gauging the value of a company’s stocks. By calculating book value per share, investors are able to if a stock’s market value is undervalued or the stocks are overvalued.
Dividend payout ratio
The dividend payout ratio is the percentage of a company’s net income that is paid out as dividends as a form of compensation for common and preferred shareholders. In other words, it is a type of ratio that calculates the dividends paid to shareholders in relation to the amount of net income that the business generated. As the metric is expressed as a percentage, it gives a picture of the amount of earnings that are paid out to shareholders as opposed to being retained or reinvested into operations. This has significant implications for the type of investors that get attracted to the stock.
A high dividend payout ratio is an indication that the company is reinvesting less money back into its business while paying out more of its profits or earnings in the form of dividends. Companies as such attract income investors who seek the assurance of having a steady stream of income to a high potential growth in share price.
Price-to-earnings ratio
The price-to-earnings ratio is a type of profitability ratio that establishes a relationship between a company’s stock price and its earnings per share. This is helpful because investors will be more interested in knowing the profitability of a company’s shares and how profitable it will be in the future. In essence, this ratio is useful in stock valuation and also the business valuation of a company as it measures the current share price of a company in relation to its earnings per share.
The P/E ratio is widely used by analysts and investors to determine whether shares are correctly valued in relation to one another. It, however, does not indicate whether the share is a bargain. Investors generally make use of the ratio to compare their own perception of the risk and a company’s growth against the market’s collective perception of the risk and growth as reflected in the current P/E ratio.
A company that has a low price-to-earnings ratio is an indication that the market perceives a higher risk or lower growth, or both as the reverse is the case with a company that has a higher P/E ratio.
Return on assets (ROA)
Return on assets is a type of profitability ratio that indicates how profitable a company is in relation to its total assets. This metric is important to corporate management, analysts, and investors as they can use it to determine a company’s efficiency in the use of its assets to generate profit. It is commonly expressed as a percentage by making use of a company’s net income and its average assets.
When a company’s ROA is high, it is an indication that the company is more efficient and productive in the management of its statement of financial position to generate profits, while a lower ROA on the other hand is an indication that the company needs to improve on its efficiency in managing its balance sheet.
Related: Solvency Ratio Formula and Example
Profitability ratios formulas, calculations, and examples
We will look at the formula for each type of profitability ratio and some examples to show how it can be calculated as well as the interpretation of the ratio to a business.
- Gross profit ratio formula
- Operating ratio formula
- Operating profit ratio formula
- Net profit ratio formula
- Return on capital employed formula
- Return on investment (ROI) formula
- Return on net worth formula
- Earnings per share formula
- Book value per share formula
- Dividend payout ratio formula
- Price earning ratio formula
- Return on assets formula
Gross profit ratio formula
The gross profit ratio formula establishes a relationship between gross profit and operational revenues. Operational revenues refer to the revenues that an enterprise earned from its operating activities which include net sales and commission. A fluctuating gross profit ratio is an indication that the business has inferior products or management practices. So the formula can be derived by subtracting the cost of goods sold from the total revenue and then dividing it by the total revenue. This ratio is usually expressed in terms of percentage as represented mathematically in the image below:
The total revenue minus the cost of goods sold results in the gross profit. The total revenue is derived by multiplying the average selling price per unit and the number of units sold while the gross profit is derived by adding the cost of raw material and direct labor costs. They are both important elements in a business and are usually found on the income statement of any company.
Example
Assuming a toy manufacturing company, based on its recent income statement, sold 30,000,000 different types of toys during the year at an average selling price of $5. The cost of raw materials in the fiscal year is $55 million and the direct labor cost of production is $30 million. We are required to calculate the company’s gross profit ratio based on the given information.
Now, we can create a table to summarize the information for simplicity.
| Particulars | Value |
|---|---|
| Number of units sold | 30,000,000 |
| Average selling price | $5 |
| Cost of raw material | $55,000,000 |
| Direct labor cost | $30,000,000 |
Based on the given information, we are required to start by calculating the total revenue and the cost of goods sold respectively.
We use the formula below to calculate the total revenue:
Total revenue = Average selling price per unit x Number of units sold
Total revenue = $5 x 30,000,000
Total revenue = $150,000,000
Secondly, we calculate the company’s cost of goods sold using the formula below:
Cost of goods sold (COGS) = Cost of raw materials + Direct labor cost
Cost of goods sold (COGS) = $55,000,000 + $30,000,000
COGS = $85,000,000
Now that we have calculated our total revenue and cost of goods sold, we can now calculate our gross profit ratio. We use the formula below:
Gross Profit Ratio = (Total revenue – Cost of goods sold) / Total revenue x 100
Gross profit ratio = ($150,000,000 – $85,000,000) / $150,000,000 x 100
Gross profit ratio = $65,000,000 / $150,000,000 x 100
Gross profit ratio = 0.4333 x 100 = 43.33%
From the calculation, this company managed a gross profit ratio of 43.33% during the fiscal year.
In conclusion, we can say that after deducting the costs related to production (cost of goods sold) of the goods from the total revenue, the gross profit is derived. However, this is not the actual profit that the company would enjoy because taxes and other expenses are yet to be deducted from this figure. When these deductions are made, then we can get the actual income a company can enjoy.
Operating ratio formula
The operating ratio formula shows the relationship between a company’s operating costs and operating revenue, also expressed in percentages. Operating costs or expenses comprise employees’ benefit expenses, depreciation and amortization expenses, and other expenses related to the business operations (other than non-operating expenses).
It is important to have in mind that the operating profit ratio and operating ratio are complementary to each other, meaning that if we deduct either of the two ratios from 100, the other will be obtained. By implication, the operating ratio plus the operating profit ratio gives rise to 100.
Basically, the essence of computing the operating ratio formula is to assess a business’s operational efficiency. As previously stated, a low operating ratio is better for a company as it leaves a higher profit margin to meet non-operating expenses, pay dividends, etc.
So, to commence this calculation, take the cost of goods sold which is otherwise known as the cost of sales. Secondly, find the total operating expenses which should be farther down the income statement, then add the total operating expenses and cost of goods sold, and place the result into the numerator of the formula. Next, divide the sum of operating expenses and the cost of goods sold by the total net sales. It is important to note that some companies include the cost of goods sold as part of their operating expenses while other companies list the two expenses separately. The operating ratio is also an income statement ratio.
Example
Based on the information contained in the income statement of Tesla as of July 2019, the company reported total revenue or net sales of $59.68 billion for the accounting period. The total cost of goods sold was $37 billion while total operating expenses were $9.59 billion.
To calculate the operating costs, we would do the addition as follows:
Operating costs = Cost of goods sold + Total operating expenses
Operating costs = $37 billion + $9.59 billion
Operating costs = 46.59 billion
Having calculated our total operating cost, we now calculate the operating ratio using the following formula:
Operating ratio = (Operating cost/Revenue from Operations) x 100
Operating ratio =( $46.59 billion / $59.68 billion) x 100
Operating ratio = 0.78 x 100 = 78%
From the calculation, Tesla’s operating ratio is high which is not favorable. It means that 78% of the company’s net sales are operating expenses. With this, it is required for Tesla’s operating ratio to be examined over several accounting periods to get an insight into whether the company is managing its operating costs effectively. Also, it is possible for investors to monitor operating expenses and the cost of goods sold separately in order to determine whether costs are either increasing or decreasing over time.
Operating profit ratio formula
The operating profit ratio formula shows the relationship between a company’s operating profit and the revenue it generated from the operations, that is net sales. The ratio is computed by dividing operating profit by revenue from operations and it is usually expressed in a percentage. Also, if a company’s operating ratio has already been calculated, then the operating profit ratio will be equal to 100 less operating ratios.
The operating profit can be obtained by adding other operating income to the gross profit, less other operating expenses. Another way to obtain the operating profit is the company’s net profit before tax plus non-operating expenses minus non-operating income, or revenue from operations minus operating cost. These three methods will arrive at the operating profit.
Example
The following data was extracted from Evergreen Enterprise: Net sales of $100,000, gross profit of $150,000, and selling expenses of $30,000. We are to calculate the operating profit ratio of this firm.
Before then, we have to find our operating profit which is the difference between the gross profit and operating expenses.
Operating profit = Gross profit – Operating expenses
Operating profit = $150,000 – ($50,000 – $30,000)
Operating Profit = $150,000 – $80,000
Operating profit = 70,000
We can now calculate our operating profit ratio using the formula:
Operating profit ratio = (Operating profit / Net sales) × 100
Operating profit ratio = (70,000 / 100,000) × 100
Operating profit ratio = 0.7 x 100 = 70%
Net profit ratio formula
The net profit ratio is calculated by dividing a company’s net profit by its net sales (revenue from operations). The net profit is obtained when we subtract the cost of revenue from operations, operating expenses, and non-operating expenses from the net sales or revenue from operations, then add non-operating income. Or one can simply obtain the net profit from a company’s income statement. The net sales are obtained by subtracting returns inwards/sales returns and allowances from the actual sales.
Example
Assuming a steel rolling company has $1,000,000 of sales in its most recent accounting period as well as sales returns of $40,000. The company’s cost of goods sold is $550,000, administrative expenses of $360,000, and the income tax rate of 35%. Based on the available information, we are required to calculate the net profit and net sales as of this period.
Net sales are calculated as follows:
Net sales = Sales – Sales returns
Net sales = $1,000,000 – $40,000
Net sales = $960,000
Next, we are to calculate our net profit after tax as follows:
Net profit before tax = Net sales – Cost of goods sold – Administrative expenses
Net profit before tax = $960,000 – $550,000 – $360,000
Net profit before tax = $50,000
Now, to get our net income/profit after tax, we subtract the tax expense from the net profit before tax. Before then, the tax is given in percentage which we need to calculate the tax amount paid.
The tax rate is 35%, so the tax expense will be calculated as 0.35 x $50,000 = $17,500.
The net income after tax is $50,000 – 17,500 = $32,500
Having calculated our net sales and net profit after tax, we calculate the net profit ratio as follows:
Net profit ratio = (Net profit/Net sales) x 100
Net profit ratio = ($32,500 / $960,000) x 100
Net profit ratio = 0.03385 x 100 = 3.39% = 3.4%
Return on capital employed formula
The return on capital employed is calculated by dividing a company’s earnings before interest and tax by the capital employed. Capital employed is the total amount of equity invested in a business which is usually calculated as total assets minus current liabilities or fixed assets plus working capital. It should also be noted that there are analysts that will make use of net operating profit in place of earnings before interest and taxes (EBIT) when calculating the return on capital employed.
Example
For example, the EBIT for Apple in 2017 is $64,000,000, its total assets amount to $375, 300,000, and its total current liabilities amount to $100,800,000, looking at the financial statements. We are to sort out the company’s capital employed by subtracting the company’s total current liabilities from its total assets thus;
Capital employed = $375,300,000 – $100,800,000 = $274,500,000
The company’s return on capital employed will be:
ROCE = (EBIT / Capital employed) x 100
ROCE = ($64,000,000 / $274,500,000) x 100
ROCE = 0.23 x 100 = 23%
If the company’s ROCE increases during the next accounting period, it is an indication of stronger profitability.
Return on investment (ROI) formula
The return on investment of a company can be computed using either the basic ROI formula or the expanded ROI formula, it is represented in a percentage. It is important to subtract the investment cost from the numerator of the basic ROI formula.
Example
Assuming $5,000 was invested in Company ABC last year, the investor then sold his shares for $5,500 recently. The return on investment will be calculated as follows:
Return on investment = (Net Profit / Cost of Investment) x 100
Return on investment = (Present Value – Cost of Investment / Cost of Investment) x 100
Computing the figures into the formula:
Return on investment = ($5,500 – $5,000 / $5,000) x 100
Return on investment = ($500 / $5,000) x 100
Return on investment = 0.1 x 100 = 10%
This simple example leaves out capital gains taxes as well as other fees involved in buying or selling the shares. However, a more realistic calculation will include these costs in the cost of investment.
Return on net worth (return on equity) formula
The return on net worth calculation is a straightforward process. To calculate the metric, simply divide the company’s net income (profit after tax) by its average shareholders’ equity. It is usually expressed in a percentage by multiplying the amount by 100. Remember that shareholders’ equity is equal to assets minus liabilities on a firm’s balance sheet which is also the accounting value that is left for shareholders after a company has settled its liabilities. ROE measures the return generated on the net assets of a company, for this reason, it is also called return on net worth.
The net income is the bottom line profit prior to the time common stock dividends are paid and reported on a firm’s income statement. Aside from net income, free cash flow is another form of profitability that analysts can use.
Return on assets can be calculated at different accounting periods to compare its change in value over time. By making comparisons in the change of the returns on equity’s net worth, from year to year or quarter to quarter, investors will be able to track changes in a firm’s performance. Also, return on equity can be calculated to compare the company’s financial performance with other firms within the same industry at a given period.
The formula is as follows:
Return on equity = (Net income / Shareholders’ equity) x 100
Net income is usually shown on the income statement but in cases whereby the information is not given, it can be calculated by subtracting expenses and cost of goods sold from a company’s revenue. Shareholders’ equity has already been explained as the difference between a firm’s total liabilities and total assets. Note that if a company has a net loss or negative shareholders’ equity, there will be no need to calculate return on equity.
Example
Assuming a company has a net income of $12,000 and shareholders’ equity of $80,000, the return on equity will be calculated using the ROE formula as follows:
Return on equity = (Net income / Shareholders’ equity) x 100
Return on equity = ($12,000 / $80,000) x 100
Return on equity = 0.15 x 100 = 15%
Assuming the company’s income increases to $16,000 during the next period and the shareholders’ equity remains the same.
Return on equity = ($16,000 / $80,000) x 100
Return on equity = 0.20 x 100 = 20%
This shows that the performance of the company is better in the recent accounting period than in the previous period.
Earnings per share formula
To calculate earnings per share, analysts take a company’s net income and subtract preferred dividends from it, then divide it by the average number of outstanding shares. As earlier stated, this financial metric is used to assess a company’s performance and profitability before investing. Higher earnings per share imply higher profitability for a company.
Types of profitability ratios: Earnings per share ratio formula.
A more elaborate formula for calculating the earnings per share is:
Earnings per share = (Net income – Preferred Dividends) / Weighted average common shares outstanding
Example
From the financial statements of Hit Technology as of the 2017 year-end, net income was $450,000, and preferred dividends paid were $30,000. At the beginning of the same year, the common shares outstanding were 50,000 shares. In the middle of the year, Hit technology issued 40,000 additional common stock. Based on the information, we are to find the company’s earnings per share.
From the information provided, the net income and preferred dividends which form part of the numerator are known. However, the weighted average of common shares outstanding, so we are to calculate that from the data given.
It has been said that at the beginning of 2017, the firm had 50,000 common shares, and in the middle of the year, the company issued common shares which were 40,000 in number. With this, we can consider 50,000 shares for the entire year and 40,000 shares for the last six months. From this information, we calculate the weighted average of shares outstanding as:
Weighted average = 50,000 (1) + 40,000 (0.5)
Weighted average = 50,000 + 20,000 = 70,000 shares.
We can now calculate the company’s earnings per share using the formula:
Earnings per share = (Net Income – Preferred Dividends) / Weighted Average Number of Common Shares
Earnings per share = ($450,000 – $30,000) / 70,000 weighted average shares
Earnings per share = $420,000 / 70,000 = $6 EPS.
Book value per share formula
A company’s book value per share can be calculated from its balance sheet because the information needed for the calculation is contained there. For instance, a company’s book value is found on the balance sheet and it is calculated as the difference between total assets and total liabilities rather than its share price in the market.
In essence, a company,s book value is calculated on the basis of common shareholders’ equity in the company. so to carry out this calculation, we subtract the preferred stock from the shareholders’ equity and then divide the figure by the number of shares outstanding or the average number of outstanding shares. The average number of outstanding shares is often used in cases whereby the amount at the end of the year may include a recent stock buyback or issuance which is bound to skew the results.
So, the result of calculating the book value per share shows the remaining value for common shareholders in an event of the company’s dissolution after all assets are liquidated and all debtors paid.
Related: Negative Book Value Per Share
Example
A rubber manufacturing company has a common equity balance of $20 million and has 2 million common stocks outstanding. The book value per share would be calculated using the following formula:
Book value per share = (Total equity − Preferred equity) / Total shares outstanding
In the information provided, we do not have preferred equity, so, the total value of equity which is $2 million will be in the numerator. Also, there will be no need to calculate average outstanding shares since there is neither stock buyback nor subsequent issuance. The weighted average can either be given or calculated based on the information given. so, our denominator will be 2 million outstanding shares, thus:
Book value per share = $20,000,000 / 2,000,000 shares outstanding
Book value per share = $10
So, this figure can be compared to the current stock price in order to know if the stock is undervalued or overvalued.
Dividend payout ratio formula
The dividend payout ratio is calculated by dividing a company’s dividends per share by its earnings per share. We explained how to calculate the earnings per share above. The result of the calculation shows the amount of earnings after tax that has been paid to shareholders.
Example
A company issued annual dividends of $2 per share, also known as the dividend per share, with $10 in diluted earnings per share. We calculate the dividend payout ratio as follows:
Dividend Payout Ratio = (Dividends per share / Earnings per share) x 100
Dividend payout ratio = ($2 / $10) x 100
Dividend payout ratio = 0.2 x 100 = 20%
Price-to-earnings ratio formula
The price-to-earnings calculation is one of the many ways of business valuation and financial analysis tools that guide one in making investment decisions. Through this, the investor sees how much he is investing for every value of annual earnings and how long it will take to recoup the price of shares if earnings remain constant.
Companies that have negative earnings which imply losses or no profit have an undefined price-to-earnings ratio which is usually shown as “not applicable” or “N/A”, although a negative price-earnings ratio may be shown in some cases.
Example
Assuming a company reported its stock price as $48 and its most recent earnings per share amount to $6. We would calculate the P/E ratio by computing these figures into the formula:
Price-to-earnings ratio = Market value per share ÷ Earnings per share
Price-to-earnings ratio = $48 / $6
Price-to-earnings ratio = $8
The result of the calculation is an indication that the buyer of the share is investing $8 of every annual earning. By implication, if earnings remain constant, it would take eight (8) years to recoup the share price.
The information above means the purchaser of the share is investing $8 for every dollar of annual earnings. This implies that if earnings stayed constant, it would take 8 years to recoup the share price.
Return on assets formula
Return on assets is calculated by dividing a company’s net income by its total assets. Because of the accounting equation of the balance sheet, it is important to note that total assets are also the sum of liabilities and shareholders’ equity. Both forms of financing are used to fund the operations of a company. Since a company’s assets are funded either through debt financing or equity financing, some analysts and investors may disregard the cost of acquiring the asset by adding back interest expense in the return on assets formula.
In other words, the impact of more debt financing is negated by adding back the cost of borrowing to the net income and using the average assets in a given accounting period as the denominator. The reason why interest expense is added is that the net income amount on the income statement does not include interest expense. Having said this, Returns on assets should not be the only factor to determine one’s investment decisions, it can be used alongside other financial metrics that are available to evaluate a company’s profitability.
Example
Assuming Jennifer and Quilala both start a fast food joint. Jennifer spends $1,500 on a container while Quilala spends $15,000 on a shop with show glasses. If for example, these were the only assets that each firm deployed and Jennifer earned $150 while Quilala earned $1,200, we can calculate their return on assets each using the formula:
Return on assets = (Net income / average total assets) x 100
For Jennifer:
Return on assets = ($150 / $1,500) x 100
Return on assets = 0.1 x 100 = 10%
For Quilala:
Return on assets = ($1,200 / $15,000) x 100
Return on assets = $0.08 x 100 = 8%
From the calculation, we see that Jennifer’s return on assets is 10% while Quilala’s return on assets is 8%. Although Quilala seemed to earn more than Jennifer, Jennifer was more efficient in using her assets to generate income than Quilala.
Related: Statement of Cash Flows Examples, and Equation
Reference: The Importance Of Profitability Indicators In Assessing The Financial Performance Of Economic Entities: https://ideas.repec.org/a/ora/journl/v1y2020i1p219-228.html
