Financial statements contain four reports that provide valuable insights into a company’s operations. The first of these is the balance sheet, which includes various account balances. Similarly, the second is the income statement, detailing a company’s financial performance. They also consist of the cash flow statement, which contains cash transactions during the year. Lastly, they include the statement of retained earnings, detailing movements in equity balances.
All these statements with the notes to the financial statements provide critical information about a company. However, this information is usually not comparable and does not provide meaningful results. Stakeholders may also use other metrics and ratios to perform a better analysis of a company’s operations. One of the classes within these ratios includes the profitability ratios.
What are Profitability Ratios?
Profitability ratios are a class of financial ratios that allows stakeholders to analyze a company’s financial performance. It assesses the ability of a company to generate earnings considering various other factors. These factors may include its revenues, operating costs, assets, equity, capital employed, etc. Profitability ratios are critical in helping investors determine whether a company is profitable.
Profitability ratios primarily focus on a company’s income statement. This financial statement records revenues, expenses, and profits. While it is helpful on its own, profitability ratios to enhance the information that the income statement provides. However, it also needs data from other financial statements, primarily the balance sheet.
Profitability ratios can also help investors analyze a company’s operational efficiency or use of resources. Usually, the higher these ratios are, the better investors would consider them. However, there are several other factors that play a role in it. Nonetheless, the most critical factor within these is a company’s profits. The rest may include comparative information, the company’s investments, future expectations, etc.
Overall, profitability ratios look at a company’s profits from various perspectives. It analyzes all of the different types of profits that companies generate. These include gross, operating, and net profits. For investors, these ratios are one of the most critical metrics in decision-making. There are two classes of profitability ratios into which all of these ratios fall.
What are the classes of Profitability Ratios?
Profitability ratios come in two classes or categories. One class looks at how a company converts its sales into profits. In contrast, the other focuses on the returns provided to investors. While both of these are crucial, they both provide different perspectives regarding a company’s profitability. These classes include margin ratios and return ratios.
Margin ratios
Margin ratios are the first class of profitability ratios. These ratios focus on how a company converts its revenues into profits. Therefore, it considers two critical factors, revenues, and profits. As mentioned, these profits may come from different metrics. These include gross profits, operating profits, and net profits. Similarly, they also focus on other factors, such as cash flows related to these sales.
Margin ratios include a wide variety of profitability ratios. These include the gross profit margin, operating profit margin, and net profit margin. Similarly, other margin ratios consist of cash flow margin, EBIT, EBITDA, EBITDAR, NOPAD, overhead ratio, and operating expense ratio.
Return ratios
Return ratios do not focus on how efficiently a company converts sales into profits. Instead, they analyze a company’s ability to generate returns to its shareholders. While the former is also helpful, investors prefer return ratios more. These ratios also consider various metrics from the balance sheet apart from a company’s profits.
Return ratios are comparatively more complex than margin ratios. Nonetheless, they provide critical information about a company’s financial performance. Some return ratios include the return on assets, return on equity, cash return on assets, return on debt, return on retained earnings, return on capital employed, etc.
What is Operating Margin Ratio?
The operating margin ratio is a type of margin profitability ratio. It analyzes the relation between a company’s operating profits and its revenues. As mentioned, margin ratios focus on how efficiently a company converts its sales into profits. Therefore, the operating margin ratio looks at the rate at which a company makes operating profits from its revenues.
The operating margin ratio is the percentage of operating profits that makes up a company’s revenues. It signifies the residual revenues after a company’s operating costs get paid. This analysis provides investors with valuable information about a company’s operational efficiency. Similarly, it shows how much profits are available for companies to cover non-operating costs.
The operating margin ratio is one of the most crucial ratios for investors. It signifies how efficient and profitable a company’s operations are. As with any other profitability ratio, the higher the ratio is, the better investors will consider it. The operating margin ratio is also one of the favorites for creditors. These parties also want to understand how much operating profits a company generates from its revenues.
Due to the emphasis on operating profits, the operating margin ratio focuses on a company’s operations. There are three components that play a significant role in its calculation. These include operating profits, revenues, and operating costs. While operating profits and revenues are directly a part of its calculation, operating expenses also contribute.
How to calculate the Operating Margin Ratio?
The formula for the operating margin ratio is straightforward after analyzing its definition. As mentioned, it is the relation between a company’s operating profits and its revenues. Usually, investors prefer it to be in the form of a percentage. Therefore, the operating margin ratio formula based on the above definition is as follows.
Operating Margin Ratio = Operating Profits / Revenues x 100
Both operating profits and revenues are a part of the income statement. Investors can extract the information from the statement and use it in the above formula to calculate the operating margin ratio. By multiplying it by 100, they will get a percentage. There is no specific level for this ratio that companies must meet for investors to consider it viable.
The operating margin ratio can provide useful insights on its own. It shows how efficiently a company converts its revenues into operating profits. More importantly, however, it can also be beneficial in making comparisons between various companies. This way, it provides better results between two companies despite different figures for operating profits and revenues.
Example
A company, ABC Co., had revenues of $10 million during an accounting period. The company’s operating profits were $2 million. Therefore, ABC Co.’s operating margin ratio will be as below.
Operating Margin Ratio = Operating Profits / Revenues x 100
Operating Margin Ratio = $2 million / $10 million x 100
Therefore, Operating Margin Ratio = 20%
The above operating margin ratio signifies that ABC Co. converted 20% of its revenues into operating profits. Although meaningful on its own, it does not provide further details on whether it is good or bad. Investors will need to compare this information to get more meaningful insights. For example, investors can check last year’s operating margin ratio for more information.
ABC Co.’s revenues for the previous year equated to $8 million. Its operating profits during last year were $1 million. Therefore, ABC Co.’s operating margin ratio the previous year was as follows.
Operating Margin Ratio = Operating Profits / Revenues x 100
Operating Margin Ratio = $1 million / $8 million x 100
Therefore, Operating Margin Ratio = 12.5%
Based on this information, it is clear that ABC Co. has increased its operating margin ratio over the year. While both the company’s operating profits and revenues have grown, it does not provide details about the operating margin. However, by comparing the operating margin ratios for both years, investors can see how the company has improved.
Conclusion
Profitability ratios provide a significant overview of a company’s financial performance. There are two classes that these ratios fall into, margin and return ratios. The operating margin ratio analyzes the relationship between a company’s operating profits and revenues. It gauges how much a company has converted its revenues into operating profits. The higher this ratio is, the better it is.
