Accounting 101 – Financial Statement Ratios
Profitability Ratio Analysis of Income Statement and Balance Sheet
The income statement and balance sheet are two important reports that show the profit and net worth of the company. Profitability ratio analyses shows how the well the company is doing in terms of profits compared to sales. They also show how well the assets are performing in terms of generating revenue.
Profitability – The Income Statement and Balance Sheet
The income statement shows the net profit of the company by subtracting expenses from gross profit (sales – cost of good sold). The balance sheet lists the value of the assets, as well as liabilities. In simple terms, the main function of the balance sheet is to show the company’s net worth by subtracting liabilities from assets. Even though the balance sheet does not report profits, there’s an important relationship between assets and profit.
The business owner normally has a lot of investment in the company’s assets. It’s important that the entrepreneur has a reasonable return on investment. One important function of profitability analysis is to show how efficiently a company uses it assets to generate income.
Return on Assets – Profitability and Asset Analysis
Return on assets is an important percentage that shows the company’s ability to use its assets to generate income. A high percentage indicates that company’s is doing a good job utilizing the company’s assets to generate income. The following formula is one method of calculating the return on assets percentage.
- Return on Assets = Net Profit/Total Assets
The net profit figure that should be used is the amount of income after all expenses, including taxes. If there is a large amount of liabilities compared to assets, this percentage takes on new meaning. A low percentage could mean that the company may have difficulties meeting its debt obligations.
Profit Margin Ratio – Operating Performance
The profit margin ratio is expressed as a percentage that shows the relationship between sales and profits. It is sometimes called the operating performance ratio because it’s a good indication of operating efficiencies. The following is the formula for calculating the profit margin.
- Profit Margin = Net Profit/Net Sales
The percentage shows how much sales it takes to generate a specific amount of net profit. For example if the profit margin is 20%, the company generates $.20 in profits for every $1.00 in sales.
Liquidity ratios are another important measure of the company’s ability to meet its short-term debt obligations. Profitability and liquidity ratios should be compared with previous ratios. Look for negative trends that may be developing. Find out what the average profitability and liquidity ratios are within the same industry for comparison. If other companies within the same industry have better numbers, this could indicate a competitive advantage.
Accounting 101 - Financial Statement Ratios
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Income Statement - Balance Sheet - Profit Ratios
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