Finance looks at profitability in a number of different ways because the appropriate measure depends on the specific question that is being asked. We’ll need to examine things a little differently from how accounting does in order to try and correct some of accounting’s distortions.
This ratio, often called Profit Margin, asks the question: for every dollar of sales, how much is left over once expenses have been paid?
Net Profit is different from Gross Profit because Gross Profit only subtracts the expenses that are related to the production of goods. Gross Profit measures Revenues minus the Costs of Goods Sold. Operating profit is different, yet again, as it takes Gross Profit and subtracts other operating costs, such as selling and administrative costs.
Net Profit/Total Assets
This ratio, often called Return on Assets, asks the question: for every dollar of Assets, how much Profit does a company generate? This corresponds to asking the question: how effective are a company’s Assets at generating Profits?
Net Profit/Net Worth
This ratio, often called Return on Equity (ROE), measures the annual return earned by shareholders. In particular, for every dollar of Equity that shareholders put into a business, what is their annual flow of income?
Relative to Net Profit, EBITDA is different in two ways. First, it begins by calculating EBIT – earnings before interest and taxes. Unsurprisingly, EBIT is nothing more than Net Income plus interest payments paid and taxes paid. This is also known as Operating Profit. To get all the way to EBITDA, we have to think about the distorting effects of non-cash charges such as depreciation and amortization. Removing those as well leaves us with EBITDA, the cash returns of a business. We’ll come back in Module 2 and develop these ideas further.
Which Ratio to Use?
Knowing which ratio answers which question is important. Drag and drop each ratio to the question it best answers.
How much value am I adding?
NET PROFIT / NET WORTH
How are my owners doing?
NET PROFIT / REVENUE
How much cash do I generate?
EBITDA / REVENUE
How efficiently do I produce profits?
NET PROFIT / TOTAL ASSETS