Is the major device for measuring the profitability of a firm over a period of time?

What Are Profitability Ratios?

Profitability ratios are a class of financial metrics that are used to assess a business's ability to generate earnings relative to its revenue, operating costs, balance sheet assets, or shareholders' equity over time, using data from a specific point in time.

Profitability ratios can be compared with efficiency ratios, which consider how well a company uses its assets internally to generate income (as opposed to after-cost profits).

Key Takeaways

• Profitability ratios assess a company's ability to earn profits from its sales or operations, balance sheet assets, or shareholders' equity.
• Profitability ratios indicate how efficiently a company generates profit and value for shareholders.
• Higher ratio results are often more favorable, but these ratios provide much more information when compared to results of similar companies, the company's own historical performance, or the industry average.

The Value of Profitability Ratios

What Do Profitability Ratios Tell You?

For most profitability ratios, having a higher value relative to a competitor's ratio or relative to the same ratio from a previous period indicates that the company is doing well. Profitability ratios are most useful when compared to similar companies, the company's own history, or average ratios for the company's industry.

Gross profit margin is one of the most widely used profitability or margin ratios. Gross profit is the difference between revenue and the costs of production—called cost of goods sold (COGS).

Some industries experience seasonality in their operations. For example, retailers typically experience significantly higher revenues and earnings during the year-end holiday season. Thus, it would not be useful to compare a retailer's fourth-quarter gross profit margin with its first-quarter gross profit margin because they are not directly comparable. Comparing a retailer's fourth-quarter profit margin with its fourth-quarter profit margin from the previous year would be far more informative.

Examples of Profitability Ratios

Profitability ratios are one of the most popular metrics used in financial analysis, and they generally fall into two categories—margin ratios and return ratios.

Margin ratios give insight, from several different angles, on a company's ability to turn sales into a profit. Return ratios offer several different ways to examine how well a company generates a return for its shareholders.

Some common examples of profitability ratios are the various measures of profit margin, return on assets (ROA), and return on equity (ROE). Others include return on invested capital (ROIC) and return on capital employed (ROCE).

Profit Margin

Different profit margins are used to measure a company's profitability at various cost levels of inquiry, including gross margin, operating margin, pretax margin, and net profit margin. The margins shrink as layers of additional costs are taken into consideration—such as the COGS, operating expenses, and taxes.

Gross margin measures how much a company makes after accounting for COGS. Operating margin is the percentage of sales left after covering COGS and operating expenses. The pretax margin shows a company's profitability after further accounting for non-operating expenses. The net profit margin is a company's ability to generate earnings after all expenses and taxes.

Return on Assets (ROA)

Profitability is assessed relative to costs and expenses and analyzed in comparison to assets to see how effective a company is deploying assets to generate sales and profits. The use of the term "return" in the ROA measure customarily refers to net profit or net income—the value of earnings from sales after all costs, expenses, and taxes. ROA is net income divided by total assets.

The more assets a company has amassed, the more sales and potential profits the company may generate. As economies of scale help lower costs and improve margins, returns may grow at a faster rate than assets, ultimately increasing ROA.

Return on Equity (ROE)

ROE is a key ratio for shareholders as it measures a company's ability to earn a return on its equity investments. ROE, calculated as net income divided by shareholders' equity, may increase without additional equity investments. The ratio can rise due to higher net income being generated from a larger asset base funded with debt.

Profitability is the primary goal of all business ventures. Without profitability the business will not survive in the long run. So measuring current and past profitability and projecting future profitability is very important.     

Profitability is measured with income and expenses. Income is money generated from the activities of the business. For example, if crops and livestock are produced and sold, income is generated. However, money coming into the business from activities like borrowing money do not create income. This is simply a cash transaction between the business and the lender to generate cash for operating the business or buying assets.

Expenses are the cost of resources used up or consumed by the activities of the business. For example, seed corn is an expense of a farm business because it is used up in the production process. Resources, such as a machine whose useful life is more than one year are used up over a period of years. Repayment of a loan is not an expense, it is merely a cash transfer between the business and the lender.

Profitability is measured with an "income statement". This is essentially a listing of income and expenses during a period of time (usually a year) for the entire business. Information File Your Farm Income Statement includes - a simple income statement analysis. An Income Statement is traditionally used to measure profitability of the business for the past accounting period. However, a "pro forma income statement" measures projected profitability of the business for the upcoming accounting period. A budget may be used when you want to project profitability for a particular project or a portion of a business.

Reasons for Computing Profitability

Whether you are recording profitability for the past period or projecting profitability for the coming period, measuring profitability is the most important measure of the success of the business. A business that is not profitable cannot survive. Conversely, a business that is highly profitable has the ability to reward its owners with a large return on their investment.

Increasing profitability is one of the most important tasks of business managers. Managers constantly look for ways to change the business to improve profitability. These potential changes can be analyzed with a pro forma income statement or a Partial Budget. Partial budgeting allows you to assess the impact on profitability of a small or incremental change in the business before it is implemented.

A variety of Profitability Ratios (Decision Tool) can be used to assess the financial health of a business. These ratios, created from the income statement, can be compared with industry benchmarks. Also, Five-Year Trend for Farm Financial Measures (Decision Tool) can be tracked over a period of years to identify emerging problems.

Accounting Methods

Cash Method of Accounting
Traditionally farmers have used the “cash method” of accounting where income and expenses are reported on the income statement when products are sold or inputs are paid for. The cash method of accounting, used by most farmers, counts an item as an expense when it is purchased, not when it is used in the business. This has been used as a method of managing tax liability from year to year. However, many non-farm business accounting systems count an item as an expense only when it is actually used in the business activities.

However, net income can be distorted with the cash method of accounting by selling more than two years crops in one year, selling feeder livestock purchased in a previous year, and purchasing production inputs in the year before they are needed.

Accrual Method of Accounting
To provide a more accurate picture of profitability, the accrual method of accounting can be used. With this method, income is reported when products are produced (not when they are sold) and expenses are reported when inputs are used (not when they are purchased). Accrual accounting uses the traditional cash method of accounting during the year but adds or subtracts inventories of farm products and production inputs on hand at the beginning and ending of the year.

A worksheet for computing Net Farm Income Statement (Decision Tool) with accrual accounting is available that allows you to prepare an accrual net income statement from income tax schedules and net worth statements. Information on creating and using a Net Farm Income Statement is also available.

Although seldom used in farming, Double Entry Accounting (Information File Understanding Double Entry Accounting) will provide results similar to accrual accounting. Double entry accounting also updates the net worth statement every time an income or expense occurs.

Defining Profitability

Profitability can be defined as either accounting profits or economic profits.

Accounting Profits (Net Income)
Traditionally, farm profits have been computed by using “accounting profits”. To understand accounting profits, think of your income tax return. Your Schedule F provides a listing of your taxable income and deductible expenses. These are the same items used in calculating accounting profits. However, your tax statement may not give you an accurate picture of profitability due to IRS rapid depreciation and other factors. To compute an accurate picture of profitability you may want to use a more accurate measure of depreciation.

Accounting profits provide an intermediate view of the viability of your business. Although one year of losses may not permanently harm your business, consecutive years of losses (or net income insufficient to cover living expenditures) may jeopardize the viability of your business.

Economic Profits
In addition to deducting business expenses, opportunity costs are also deducted when computing “economic profits”. Opportunity costs relate to your money (net worth), your labor and your management ability. If you were not farming, you would have your money invested elsewhere and be employed in a different career. Opportunity cost is the investment returns given up by not having your money invested elsewhere and wages given up by not working elsewhere. These are deduced, along with ordinary business expenses, in calculating economic profit.

Economic profits provide a long-term perspective of your business. If you can consistently generate a higher level of personal income by using your money and labor elsewhere, you may want to examine whether you want to continue farming.

Profitability is not Cash Flow

People often mistakenly believe that a profitable business will not encounter cash flow problems. Although closely related, profitability and cash flow are different. An income statement lists income and expenses while the cash flow statement lists cash inflows and cash outflows. An income statement shows profitability while a cash flow statement shows liquidity.

Many income items are also cash inflows. The sale of crops and livestock are usually both income and cash inflows. The timing is also usually the same (cash method of accounting) as long as a check is received and deposited in your account at the time of the sale. Many expense items are also cash outflow items. The purchase of livestock feed is both an expense and a cash outflow item. The timing is also the same (cash method of accounting) if a check is written at the time of purchase.

However, there are many cash items that are not income and expense items, and vice versa. For example, the purchase of a tractor is a cash outflow if you pay cash at the time of purchase as shown in the example in Table 2. If money is borrowed for the purchase using a term loan, the down payment is a cash outflow at the time of purchase and the annual principal and interest payments are cash outflows each year as shown in Table 3.

The tractor is a capital asset and has a life of more than one year. It is included as an expense item in an income statement by the amount it declines in value due to wear and obsolescence. This is called “depreciation”. The depreciation expense is listed every year. In the tables below a $70,000 tractor is depreciated over seven years at the rate of $10,000 per year.

Depreciation calculated for income tax purposes can be used. However, to accurately calculate net income, a more realistic depreciation amount should be used to approximate the actual decline in the value of the machine during the year.

In Table 3, where the purchase is financed, the amount of interest paid on the loan is included as an expense, along with depreciation, because interest is the cost of borrowing money. However, the principal payments are not an expense but merely a cash transfer between you and your lender.

Other Financial Statements

An income statement is only one of several financial statements that can be used to measure the financial strength of a business. Other common statements include the balance sheet or net worth statement and the cash flow statement, although there are several other statements that may be included.

These statements fit together to form a comprehensive financial picture of the business. The balance sheet or Net Worth Statement shows the solvency of the business at a specific point in time. Statements are often prepared at the beginning and ending of the accounting period (i.e. January 1). The statement records the assets of the business and their value and the liabilities or financial claims against the business (i.e. debts). The amount by which assets exceed liabilities is the net worth of the business. The net worth reflects the amount of ownership of the business by the owners.

The Cash Flow Statement is also a dynamic statement that records the flow of cash into and out of the business during the accounting period. A positive (negative) cash flow will increase (decrease) the working capital of the business. Working capital is defined as the amount of money used to facilitate business operations and transactions. It is calculated as current assets (cash or near cash assets) less current liabilities (liabilities due during the upcoming accounting period – i.e. year).

A Complete set of Financial Statements (Decision Tool), including the beginning and ending net worth statements, the income statement, the cash flow statement, the statement of owner equity and the financial performance measures is available to do a comprehensive financial analysis of your business. A hand worksheet version of the Decision Tool is also available.

To help assess the financial health of your business, Financial Performance Measures allows you to give your business a check-up and helps you to understand what these performance measures mean for your business.

Reviewed by Ann M. Johanns, extension program specialist, 515-337-2766,
Originally prepared by Don Hofstrand, retired extension value added agriculture specialist,

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