This lesson introduces three profitability ratios that show how effectively a company turns sales, assets, and invested equity into income. These measures help managers and investors assess financial performance, while remembering that ratios are most useful when compared with relevant benchmarks.
Profit margin measures the portion of sales revenue that remains as income. It answers the question: how much profit does the company generate from each dollar of sales?
All flashcards
Profit margin
Net income divided by net sales; it measures income generated per sales dollar.
Return on total assets (ROA)
Net income divided by average total assets; it measures income relative to the company’s assets.
Return on equity (ROE) for common stockholders
Income available to common stockholders divided by average stockholders’ equity; preferred dividends are deducted from net income when applicable.
Average total assets divided by average stockholders’ equity; it indicates financial leverage.
Quiz questions
Which three ratios are multiplied in the three-part DuPont equation for ROE?Answer: Profit margin, total asset turnover, and equity multiplier.
Why can two companies with similar ROE have different DuPont profiles?Answer: Their ROE may be driven by different combinations of margin, asset use, and leverage.
If a company’s equity multiplier is greater than 1, what does that indicate?Answer: Its assets exceed stockholders’ equity, so other financing sources support some assets.
When a company has a weak profit margin, which areas might it investigate?Answer: Pricing, costs, or product mix.
Why might a DuPont ROE estimate differ from a direct ROE calculation?Answer: Rounding or inconsistent income definitions can produce a difference.
Based on Principles of Finance by Julie Dahlquist, Rainford Knight (OpenStax), licensed CC BY 4.0. Adapted into a summary, flashcards and quizzes.