Financial Ratio Analysis

To measure profitability, a firm's profits can be related to its sales, equity, or stock value. Profitability ratios measure how well the firm is using its resources to generate profit and how efficiently it is being managed. The main profitability ratios are net profit margin, return on equity, and earnings per share.

The ratio of net profit to net sales is the net profit margin, also called return on sales. It measures the percentage of each sales dollar remaining after all expenses, including taxes, have been deducted. Higher net profit margins are better than lower ones. The net profit margin is often used to measure the firm's earning power. "Good" net profit margins differ quite a bit from industry to industry. A grocery store usually has a very low net profit margin, perhaps below 1 percent, whereas a jewelry store's net profit margin would probably exceed 10 percent. Delicious Desserts' net profit margin for 2018 is 11.9 percent. In other words, Delicious Desserts is earning 11.9 cents on each dollar of sales.

Exhibit 14.8 For giant retailers such as Macy's, the high expense of operating a brick-and-mortar store counters the elevated markup on merchandise, resulting in slim profit margins. Because competition forces marketers to keep prices low, it is often a retailer's cost-cutting strategy, not initial markup or sales volume, that determines whether a business will be profitable. What expenses other than payroll and the cost of merchandise affect a retailer's net profit margin?

The ratio of net profit to total owners' equity is called return on equity (ROE). It measures the return that owners receive on their investment in the firm, a major reason for investing in a company's stock. Delicious Desserts has a 40.9 percent ROE for 2018. On the surface, a 40.9 percent ROE seems quite good. But the level of risk in the business and the ROE of other firms in the same industry must also be considered. The higher the risk, the greater the ROE investors look for. A firm's ROE can also be compared to past values to see how the company is performing over time.

Earnings per share (EPS) is the ratio of net profit to the number of shares of common stock outstanding. It measures the number of dollars earned by each share of stock. EPS values are closely watched by investors and are considered an important sign of success. EPS also indicates a firm's ability to pay dividends. Note that EPS is the dollar amount earned by each share, not the actual amount given to stockholders in the form of dividends. Some earnings may be put back into the firm. Delicious Desserts' EPS for 2018 is $3.22.