Company's Financial Accounting
Business efficiency. Profitability calculations and its assessment: examples and analysis
Coefficients Net profit margin, ROI and ROCE, ROE
Indicator: Net profit margin or Net income margin (in Finnish, nettotulosprosentti)
The net profit margin represents the percentage of revenue of business operations left after all expenses have been deducted from total sales. It shows how much of each euro earned by an enterprise as revenue converts into profit, in other words this indicator assesses how much profit the company is generating from its sales.
Net profit margin can be calculated using Income Statement Data
In our example we have:
It is possible to compare the profitability of several businesses regardless of their size, but the comparison should be done within the same industry, since the companies referred to one business sphere probably will have approximately the same cost structures and business environment in general. Profit margins can vary by industry and depends on the structure of the business, but generally if it exceeds the 10%, then this result is considered as an excellent. The profit margin result in 10% means that for each €1 of revenue the company earns € 0,10 in net profit.
In our example we have got the profit margin in 11,2% and it means that for each €1 of revenue the company earns € 0,112 in net profit.
Indicators: ROI, ROCE (in Finnish, sijoitetun pääoman tuotto, pääoman tuottoaste)
Next profitability ratio is ROI or return on investment and ROCE or return on capital employed. Both indicators ROI and ROCE is a similar measure, which help to determine the company's efficiency to utilize its capital. The difference is that ROI can be used to assess the concrete investment decision of particular department, whereas ROCE can be used at a company level to appraise the efficiency of company's capital investments. The ratios measure the relative profitability, i.e. the return from invested capital.
To calculate this ratio, we will need the data from income statement of the current reporting period, and balance sheet data from previous reporting period. Let's consider Income Statement and Balance Sheet of our hypothetical company X.
The result of ROI formula is in a percentage, and is calculated as follows:
In our example we have:
The goal is to get a high ROI, since the higher the ratio result, the greater the benefit earned. The minimum return on investment have to be equal to the interest that a company pays on its debt’s obligations. For a profitable company, the return on investment should be substantially higher than the loan interest defrayals.
The recommended indicative values for ROI result interpretation are:
| more than 15% | Excellent |
| 9% - 15% | Good |
| 6% - 9% | Satisfactory |
| 3% - 6% | Minimum admissible (should avoid) |
| less than 3% | Weak and crisis |
In our calculations we have got the return on investment ROI equal to 33,9 %, that is an excellent result.
Indicator: ROE (in Finnish, oman pääoman tuotto, %)
Return on equity or ROE is another important profitability metric, which expressed as a percentage. It shows what is the total return on equity capital and reflects the company’s ability to turn its assets into profit. In other words, this ratio measures how much profit each euro of the company's shareholder's equity creates.
The formula for ROE is the following:
Shareholders' Equity can be calculated using Balance Sheet Data and by two different ways:
- 1st Method: Shareholders' Equity = TOTAL ASSETS - TOTAL LIABILITIES or
- 2nd Method: Shareholders' Equity = Capital stock + Retained earnings + Profit of the financial year
ROE can be calculated using Balance Sheet data and Income Statement data:
The recommended indicative values for ROE result interpretation are:
| more than 20% | Excellent |
| 20% | Good |
| 10% - 19% | Satisfactory |
| less than 10% | Weak |
In our calculations we have got the return on equity or ROE equal to 35,9 %, that is an excellent result.