what can profitability ratios tell you 
profitability ratios can shed light on how well a company s management is operating a business investors can use them along with other research to determine whether or not a company might be a good investment broadly speaking higher profitability ratios can point to strengths and advantages that a company has such as the ability to charge more or less for products and to maintain lower costs a company s profitability ratios are most useful when compared to those of similar companies the company s own performance history or average ratios for the company s industry normally a higher value relative to previous value indicates that the company is doing well return ratios are metrics that compare returns received to investments made by bondholders and shareholders they reflect how well a business manages the investments to produce value for investors types of profitability ratiosprofitability ratios generally fall into two categories margin ratios and return ratios margin ratios give insight from several different angles into a company s ability to turn sales into profit return ratios offer several different ways to examine how well a company generates a return for its shareholders using the money they ve invested some common examples of the two types of profitability ratios are margin ratiosdifferent profit margins are used to measure a company s profitability at various cost levels of inquiry these income statement profit margins include gross margin operating margin pretax margin and net profit margin the margins between profit and costs expand when costs are low and shrink as layers of additional costs e g cost of goods sold cogs operating expenses and taxes are taken into consideration gross profit margin also known as gross margin is one of the most widely used profitability ratios gross profit is the difference between sales revenue and the costs related to the products sold the aforementioned cogs gross margin compares gross profit to revenue a company with a high gross margin compared to its peers likely has the ability to charge a premium for its products it may indicate the company has an important competitive advantage on the other hand a pattern of declining gross margins may point to increased competition 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 be most informative and useful to compare a retailer s fourth quarter profit margin with its or its peers fourth quarter profit margin from the previous year operating margin is the percentage of sales left after accounting for cogs as well as normal operating expenses e g sales and marketing general expenses administrative expenses it compares operating profit to revenue operating margin can indicate how efficiently a company manages its operations that can provide insight into how well those in management keep costs down and maximize profitability a company with a higher operating margin than its peers can be considered to have more ability to handle its fixed costs and interest on obligations it most likely can charge less than its competitors and it s better positioned to weather the effects of a slowing economy the pretax margin shows a company s profitability after accounting for all expenses including non operating expenses e g interest payments and inventory write offs except taxes as with other margin ratios pretax margin compares revenue to costs it can signal management s ability to run a business efficiently and effectively by boosting sales as it lowers costs a company with a high pretax profit margin compared to its peers can be considered a financially healthy company with the ability to price its products and or services most appropriately the net profit margin or net margin reflects a company s ability to generate earnings after all expenses and taxes are accounted for it s obtained by dividing net income into total revenue net profit margin is seen as a bellwether of the overall financial well being of a business it can indicate whether company management is generating enough profit from its sales and keeping all costs under control its drawback as a peer comparison tool is that because it accounts for all expenses it may reflect one time expenses or an asset sale that would increase profits for just that period other companies won t have the same one off transactions that s why it s a good idea to look at other ratios such as gross margin and operating margin along with net profit margin the cash flow margin measures how well a company converts sales revenue to cash it reflects the relationship between cash flows from operating activities and sales cash flow margin is a significant ratio for companies because cash is used to buy assets and pay expenses that makes the management of cash flow very important a greater cash flow margin indicates a greater amount of cash that can be used to pay for example shareholder dividends vendors and debt payments or to purchase capital assets a company with negative cash flow is losing money despite the fact that it s producing revenue from sales that can mean that it might need to borrow funds to keep operating a limited period of negative cash flow can result from cash being used to invest in e g a major project to support the growth of the company one could expect that that would have a beneficial effect on cash flow and cash flow margin in the long run return ratiosreturn ratios provide information that can be used to evaluate how well a company generates returns and creates wealth for its shareholders given a certain level of investment deployed to generate such profits these profitability ratios compare investments in assets or equity to net income those measurements can indicate a company s capability to manage these investments profitability is assessed relative to costs and expenses it s analyzed in comparison to assets to see how effective a company is at 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 that a company has amassed the greater the 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 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 a high roe can be a sign to investors that a company may be an attractive investment it can indicate that a company has the ability to generate cash and not have to rely on debt this return ratio reflects how well a company puts its capital from all sources including bondholders and shareholders to work to generate a return for those investors it s considered a more advanced metric than roe because it involves more than just shareholder equity it considers all the capital that is being used by the company to generate the profits roic compares after tax operating profit to total invested capital again from debt and equity it s used internally to assess appropriate use of capital roic is also used by investors for valuation purposes roic that exceeds the company s weighted average cost of capital wacc can indicate value creation and a company that can trade at a premium 