Profitability ratios: margins and returns on capital

What do the margins measure?

Profit per unit of revenue at each level of the income statement. Profitability ratios come in two families: returns on sales (margins) and returns on investment. The margins are the common-size income statement in ratio form.

Gross profit margin shows what is left after the direct cost of sales, and reflects pricing power and product cost. Operating profit margin adds operating expenses, so it rises faster than the gross margin when overheads are well controlled. Pretax margin is after interest, and it picks up the effect of leverage and non-operating items. Net profit margin is after tax.

$$\text{Gross margin} = \frac{\text{gross profit}}{\text{revenue}}$$

$$\text{Operating margin} = \frac{\text{operating income}}{\text{revenue}}$$

$$\text{Pretax margin} = \frac{\text{EBT}}{\text{revenue}}$$

$$\text{Net margin} = \frac{\text{net income}}{\text{revenue}}$$

Many analysts use earnings before interest and taxes (EBIT) as a shortcut for operating income. The two differ when there are non-operating items such as investment gains, so compute them consistently across companies and years. Use net income adjusted for non-recurring items when judging future profitability.

What do returns on investment measure?

Profit per unit of capital. The key is to pair the profit with the capital that earned it, and to use average balances.

Memorize

If profit is measured before interest, it belongs to everyone who funded the assets, so divide by assets or by debt plus equity.

$$\text{Operating ROA} = \frac{\text{operating income (EBIT)}}{\text{average total assets}}$$

$$\text{ROIC} = \frac{\text{EBIT} \times (1 - t)}{\text{average (short-term debt + long-term debt + equity)}}$$

Operating ROA and return on invested capital (ROIC) both exclude interest from the numerator. ROIC taxes the EBIT, so it shows the after-tax return on all capital employed. A pre-tax variant, EBIT over average debt plus equity, is sometimes called return on total capital . Use whichever definition the question gives.

$$\text{Return on total capital} = \frac{\text{EBIT}}{\text{average (debt + equity)}}$$

If profit is measured after interest, it belongs to owners, so divide by equity.

$$\text{ROA} = \frac{\text{net income}}{\text{average total assets}}$$

$$\text{ROE} = \frac{\text{net income}}{\text{average total equity}}$$

$$\text{ROCE} = \frac{\text{net income} - \text{preferred dividends}}{\text{average common equity}}$$

Return on assets (ROA) is the awkward one: net income is after interest but assets are funded by lenders too. Some analysts fix the mismatch by adding back after-tax interest.

$$\text{ROA}_{adj} = \frac{\text{NI} + \text{interest} \times (1 - t)}{\text{average total assets}}$$

Return on equity includes all equity, preferred and minority included. Return on common equity removes the preferred holders’ share from both sides.

Profitability ratios

• Return on sales Memorize profit ÷ revenue
  • Gross profit margin gross profit
  • Operating profit margin operating income
  • Pretax margin EBT, after interest
  • Net profit margin net income
• Return on investment Memorize profit ÷ average capital
  • Operating ROA EBIT ÷ assets
  • ROA net income ÷ assets
  • ROIC after-tax EBIT ÷ debt + equity
  • ROE net income ÷ equity
  • Return on common equity after preferred dividends

Worked example: Sandmere Retail

Income statement (USD m): revenue 12,000, cost of sales 7,200, EBIT 1,400, interest 200, pretax income 1,200, tax 300 (25%), net income 900. Balance sheet, start and end of year: total assets 7,000 and 8,000, debt 3,000 and 3,200, equity 3,000 and 3,600. There is no preferred stock.

How do margins and returns connect?

Margins are per unit of sales and returns are per unit of capital. The bridge is turnover: ROA = net margin × total asset turnover, and ROE = ROA × financial leverage. Sandmere’s ROA of 12.0% is 7.5% × 1.6, and its ROE of 27.3% is 12.0% × 2.27. The next lesson builds on exactly this chain.

Exam tip Before computing a return, ask two questions: is the profit before or after interest, and does the capital include creditors? Then pair them.

Go deeper Why net income over assets is an imperfect ROA

Net income is the owners’ profit, but total assets are funded by owners and lenders. Two companies with identical operations but different debt would report different ROAs because one pays more interest. Operating ROA, or ROA with after-tax interest added back, removes the financing effect, so it compares operations fairly. The cost is that the figure no longer ties to net income, so be consistent across the companies and years you compare.