Financial Ratio
Tests of Profitability
Profitability is a primary measure of the overall success of a company and is necessary for a company’s survival. Several test of profitability focus on measuring the adequacy of income by comparing it to other items reported on the financial statements.
1) Return on Equity:
One of the most important profitability ratios is return on equity (ROE). ROE is the amount of net income returned as a percentage of shareholders equity. Return on equity measures a corporation's profitability by revealing how much profit a company generates with the money shareholders have invested. The return on equity ratio is computed as follows:
Return on Equity = | Net Income | | Average Shareholder's Equity |
Simply, ROE indicates know how well management is employing the shareholders’ capital invested in the company. A business that has a high return on equity is more likely to be capable of generating cash internally. For the most part, the higher a company's return on equity compared to its industry, the better.
2) Return on Assets:
Return on Assets is an indicator of how profitable a company is relative to its total assets. ROA shows how efficient management is at using its assets to generate earnings.
Return on Assets = | Net Income + Interest Expense | | Average Total Assets |
ROA gives investors an idea of how effectively the company is converting the money it has to invest into net income. The higher the ROA number, the better, because the company is earning more money on less investment.
3) Financial Leverage Percentage:
Financial Leverage Percentage is obtained by subtracting the return on assets from the return on equity. The ratio represents the advantage or disadvantage that occurs when a company’s ROE differs from its ROA. Ratios will vary greatly between companies, but in general, a company wants to have positive leverage, regardless of the how high or low the ratio.
Financial Leverage Percentage = Return on
Profitability is a primary measure of the overall success of a company and is necessary for a company’s survival. Several test of profitability focus on measuring the adequacy of income by comparing it to other items reported on the financial statements.
1) Return on Equity:
One of the most important profitability ratios is return on equity (ROE). ROE is the amount of net income returned as a percentage of shareholders equity. Return on equity measures a corporation's profitability by revealing how much profit a company generates with the money shareholders have invested. The return on equity ratio is computed as follows:
Return on Equity = | Net Income | | Average Shareholder's Equity |
Simply, ROE indicates know how well management is employing the shareholders’ capital invested in the company. A business that has a high return on equity is more likely to be capable of generating cash internally. For the most part, the higher a company's return on equity compared to its industry, the better.
2) Return on Assets:
Return on Assets is an indicator of how profitable a company is relative to its total assets. ROA shows how efficient management is at using its assets to generate earnings.
Return on Assets = | Net Income + Interest Expense | | Average Total Assets |
ROA gives investors an idea of how effectively the company is converting the money it has to invest into net income. The higher the ROA number, the better, because the company is earning more money on less investment.
3) Financial Leverage Percentage:
Financial Leverage Percentage is obtained by subtracting the return on assets from the return on equity. The ratio represents the advantage or disadvantage that occurs when a company’s ROE differs from its ROA. Ratios will vary greatly between companies, but in general, a company wants to have positive leverage, regardless of the how high or low the ratio.
Financial Leverage Percentage = Return on