Profitability Measures

The three measures we discuss in this section are probably the best known and most widely used of all financial ratios. In one form or another, they are intended to measure how efficiently the firm uses its assets and how efficiently the firm manages its operations. The focus in this group is on the bottom line, net income.

Profit Margin Companies pay a great deal of attention to their profit margin: Net income

Profit margin

This tells us that Prufrock, in an accounting sense, generates a little less than 16 cents in profit for every dollar in sales.

All other things being equal, a relatively high profit margin is obviously desirable. This situation corresponds to low expense ratios relative to sales. However, we hasten to add that other things are often not equal.

For example, lowering our sales price will usually increase unit volume, but will normally cause profit margins to shrink. Total profit (or, more important, operating cash flow) may go up or down; so the fact that margins are smaller isn't necessarily bad. After all, isn't it possible that, as the saying goes, "Our prices are so low that we lose money on everything we sell, but we make it up in volume"?7

Return on Assets Return on assets (ROA) is a measure of profit per dollar of assets. It can be defined several ways, but the most common is:

Return on assets

Net income Total assets

Return on Equity Return on equity (ROE) is a measure of how the stockholders fared during the year. Because benefiting shareholders is our goal, ROE is, in an accounting sense, the true bottom-line measure of performance. ROE is usually measured as:

Net income

Return on equity =-

Total equity

Ross et al.: Fundamentals of Corporate Finance, Sixth Edition, Alternate Edition

II. Financial Statements and Long-Term Financial Planning

3. Working with Financial Statements

© The McGraw-Hill Companies, 2002

CHAPTER 3 Working with Financial Statements

For every dollar in equity, therefore, Prufrock generated 14 cents in profit, but, again, this is only correct in accounting terms.

Because ROA and ROE are such commonly cited numbers, we stress that it is important to remember they are accounting rates of return. For this reason, these measures should properly be called return on book assets and return on book equity. In fact, ROE is sometimes called return on net worth. Whatever it's called, it would be inappropriate to compare the result to, for example, an interest rate observed in the financial markets. We will have more to say about accounting rates of return in later chapters.

The fact that ROE exceeds ROA reflects Prufrock's use of financial leverage. We will examine the relationship between these two measures in more detail next.

ROE and ROA

Because ROE and ROA are usually intended to measure performance over a prior period, it makes a certain amount of sense to base them on average equity and average assets, respectively. For Prufrock, how would you calculate these? We first need to calculate average assets and average equity:

Average assets = ($3,373 + 3,588)/2 = $3,481 Average equity = ($2,299 + 2,591)/2 = $2,445

With these averages, we can recalculate ROA and ROE as follows:

$363

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