December 5, 2021
Three things an organization needs to prove to investors, lenders, and shareholders are 1) profitability, 2) liquidity, and 3) solvency. We do these measurements with a series of ratios obtained through close analysis of the balance sheet and income statement. Each ratio tells a different part of the whole story. Analysts look at liquidity ratios to determine if the company can pay its bills, solvency ratios to see long-term viability, and profitability ratios to show income and operational success (Kimmel et al., 2019). The different ratios to determine solvency, liquidity, and profitability are not usually used independently; instead, analysts look at all of them to tell a complete and detailed story of the organization’s overall health (ProfAlldredge, 2015). As profitability is critical to gaining investors and growing a business, those ratios are analyzed and discussed here.
The Profitability Ratios
Profitability ratios help analysts or investors study the investment risk. Ratios that determine a company’s profitability include return on equity, return on assets, asset turnover, payout, earnings per share, price-earnings, gross profit rate, profit margin, and return on common stockholders’ equity (Kimmel et al., 2019; ProfAlldredge, 2015). These ratios measure a company’s operational success for a given period (ProfAlldredge, 2015). Shareholders like to look at these ratios to determine if the company is a worthy investment. The ratios determine whether the company can obtain debt and financing (Kimmel et al., 2019). This essay analyzes the top three profitability ratios: earnings per share, gross profit rate, and profit margin.
Analyzing Financial Statements for Profitability Ratios
Investors and creditors evaluate the health of a business through financial statement analysis. To calculate the earnings per share (EPS) ratio, subtract the preferred dividends from the net income, then divide that by the average number of common shares currently outstanding (Kimmel et al., 2019; Wilkins, 2021). The weighted average is calculated by multiplying the outstanding shares by the period in which they are covered; then, do this for all portions, adding them at the end (Murphy, 2020). This ratio will give investors a picture of how much they would earn back on their investment. Pricing products and services can be challenging, as many factors in the market determine the fair price. The gross profit rate helps businesses discover if their price is adequately above their cost of goods sold enough to drive profit (Kimmel et al., 2019). To calculate the gross profit rate, first subtract the cost of goods sold from net sales to determine the gross profit, then divide gross profit by net sales (Kimmel et al., 2019). A declining or low number indicates more competition and less profitability. The return on assets is another important profitability ratio, as it shows the amount of money earned on invested dollars (Kimmel et al., 2019). The profit margin affects the return on assets, and it measures the percentage of sales dollars that affect the net income (Kimmel et al., 2019). The income statement provides the information necessary for this analysis. To calculate the profit margin, divide the net income by the net sales for a specific period (Kimmel et al., 2019). A higher percentage indicates greater profitability or growth (Kimmel et al., 2019). These three profitability ratios tell the story of management’s effectiveness and operational success.
Profitability Ratios for UnitedHealth Group (UHG)
UnitedHealth Group (UNH) is a multinational managed healthcare organization. Its most recent financial statements are used as an example. The profit margin was calculated to determine the percentage of profitability for each dollar spent—telling analysts, executives, managers, and shareholders how much money is made on the sale of services provided. UNH’s current profit margin as of the quarter ending September 30, 2021, is 5.6%, calculated by dividing net income by net sales (UnitedHealth Group, n.d.). The profit margin shows the company has good profitability, as they made approximately $4,051B from the revenue received.
While important, profitability ratios only tell a partial story of the organization’s health. Investors, lenders, and shareholders should further investigate liquidity and solvency ratios to ensure the company will also last a while and be able to pay the bills, on top of being profitable. These ratios are crucial elements in a company’s financial reporting and its ability to obtain capital.
References
Kimmel, P. D., Weygandt, J. J., & Kieso, D. E. (2019). Accounting: Tools for Business Decision Making (7th Edition). Wiley Global Education US. https://wileyplus.vitalsource.com/books/9781119494799
Murphy, C. (2020, October 27). Weighted average of outstanding shares. Investopedia. Retrieved on October 15, 2021, from https://www.investopedia.com/ask/answers/05/weightedoutstandingshares.asp
ProfAlldredge. (2015, July 15). Financial Analysis: Overview of Ratio Analysis. [Video]. YouTube. https://www.youtube.com/watch?v=FT2rOR6CxGE
Wilkins, G. (2021, March 9). 6 basic financial ratios and what they reveal. Investopedia. Retrieved on October 15, 2021, from https://www.investopedia.com/financial-edge/0910/6-basic-financial-ratios-and-what-they-tell-you.aspx
