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Lesson 5 of 6Financial Analysis and Decision Making
Unit 4 · Lesson 5 of 6

Profitability and Market Ratios

Profitability ratios measure how well a company turns sales, assets and owners' money into profit, market ratios connect that profit to each share and its price, and every ratio has limitations that must be kept in mind before drawing a conclusion.

5 min read1 quick check9 practice questionsInteractiveAsk AI about this →

Key things to remember

  1. 1Gross profit margin ; net profit margin .
  2. 2Return on assets return on equity
  3. 3EPS
  4. 4Book value per common share
  5. 5P/E ; dividend yield
  6. 6Ratios depend on accounting choices, historical cost and one-day snapshots, so compare carefully and read the notes.

A company can be perfectly able to pay its bills and still be a poor business if it barely earns anything. Profitability ratios answer the owner's question: for every dollar of sales, of assets, or of money I invested, how much profit came back? Market ratios answer the investor's question: what is one share entitled to, and is its price reasonable? These are the numbers quoted in business news and on stock-market websites. We continue with Maple Outdoor Ltd.'s 2026 figures: net income $75,000, 50,000 common shares outstanding all year, no preferred shares, and a share price of $18.00 at year end.

Liquidity — can it pay its short-term debts?Current ratioCurrent assetsCurrent liabilitiesQuick ratioCash + short-terminvestments + receivablesCurrent liabilitiesWorking capitalCurrent assets − CurrentliabilitiesEfficiency (turnover) — how well does it use its assets?Receivables turnoverNet credit salesAverage accounts receivableCollection period (days)365Receivables turnoverInventory turnoverCost of goods soldAverage inventorySolvency — can it carry its debt over the long term?Debt ratioTotal liabilitiesTotal assetsDebt-to-equityTotal liabilitiesTotal equityTimes interest earnedIncome before interest andincome taxInterest expenseProfitability — how much does it earn?Gross profitmarginGross profitNet salesNet profit marginNet incomeNet salesReturn on assetsNet incomeAverage total assetsReturn on equityNet incomeAverageshareholders' equityMarket — what is it worth to a shareholder?Earnings per share (EPS)Net income − preferreddividendsWeighted average number ofcommon sharesBook value per commonshareCommon shareholders' equityNumber of common sharesoutstandingPrice-earnings ratioMarket price per shareEarnings per share
Fig 1Profitability and market ratios sit at the top of the ratio families, using income statement figures over balance sheet or per-share bases.

Profitability ratios: margins and returns

RatioFormulaMaple 2026Maple 2025Industry
Gross profit marginGross profit / net sales$320,000 / $800,000 = 40.0%38.0%37.0%
Net profit marginNet income / net sales$75,000 / $800,000 = 9.4%7.5%6.0%
Return on assetsNet income / average total assets$75,000 / $650,000 = 11.5%n/a8.0%
Return on equityNet income / average shareholders' equity$75,000 / $355,000 = 21.1%n/a15.0%
Profitability ratios, rounded to one decimal place. Averages: total assets ($600,000 + $700,000) / 2 = $650,000; equity ($320,000 + $390,000) / 2 = $355,000.
  • Gross profit margin shows pricing power and buying efficiency: 40 cents of every sales dollar remains after paying for the goods.
  • Net profit margin shows what is left after every expense, including interest and tax: 9.4 cents per sales dollar.
  • Return on assets (ROA) shows how well management uses everything the company controls, however it was financed. Average total assets are used because profit was earned over the whole year.
  • Return on equity (ROE) shows the return on the owners' investment. If there are preferred shares, use net income minus preferred dividends over average common shareholders' equity.
  • Maple's ROE (21.1%) is well above its ROA (11.5%) because part of its assets is financed with debt that costs less than the assets earn. That is the leverage effect from the first lesson.
VideoCovers gross, operating and net profit margins, return on assets and return on equity. Return on capital employed is extra and not used in this course.Watch on YouTube

Earnings per share and book value per share

Earnings per share (EPS) is the profit belonging to each common share. Preferred dividends are subtracted because that part of the profit belongs to preferred shareholders. The denominator is a weighted average because shares issued partway through the year were only available to earn profit for part of it: multiply each block of shares by the fraction of the year it was outstanding. Maple issued its 5,000 new shares on January 1, 2026, so all 50,000 shares were outstanding all year and EPS , up from in 2025.

Book value per common share is the amount of recorded equity behind each common share: what each share would receive in theory if assets sold for exactly their book values and all debts were paid. Maple's is . It uses shares outstanding at the balance-sheet date, not a weighted average, because equity is measured on that date. A market price above book value ($18.00 versus $7.80) is normal for a profitable company, because investors value future earnings and assets such as brand reputation that the balance sheet does not record.

Market ratios: price-earnings and dividend yield

RatioFormulaMaple 2026What it tells you
Price-earnings (P/E)Market price per share / EPS$18.00 / $1.50 = 12.0Investors pay $12 for each $1 of current annual earnings. A higher P/E usually means investors expect faster growth (or see lower risk).
Dividends per shareCommon dividends / common shares outstanding$25,000 / 50,000 = $0.50Cash paid to each common share during the year.
Dividend yieldDividends per share / market price per share$0.50 / $18.00 = 2.8%The cash return from dividends on the current share price. Mature companies tend to have higher yields; growth companies often keep their earnings.
Market ratios for Maple Outdoor, using a year-end share price of $18.00.
Quick checkTry it before you read on
1
A share trades at $40.00 and EPS is $2.50. What is the price-earnings ratio? Answer to one decimal place.

Limitations of ratio analysis

  • Ratios are only as reliable as the statements behind them. Errors, aggressive estimates or fraud flow straight into every ratio.
  • Different accounting choices reduce comparability. Two companies using FIFO and weighted average, or straight-line and declining-balance amortization, report different profits and assets from identical events; check the notes.
  • A balance sheet is one day's snapshot. A retailer with a December 31 year end may show unusually high cash and low inventory after the holiday season.
  • Historical cost ignores inflation and current values, so an old, fully amortized building can make ROA look higher than it really is.
  • Industry averages hide variety, and diversified companies may not fit any one industry.
  • Ratios point to questions, not answers. A falling margin could be a problem or a deliberate price cut to win market share; read the MD&A.
  • Non-financial factors matter too: management quality, competition, technology change and the economy do not appear in any ratio.
Read ratios in groups
No single ratio decides anything. A strong ROE paired with a high debt-to-equity may simply reflect leverage risk. A high P/E with falling margins may mean investors are too optimistic. Always combine profitability with liquidity and solvency, and look at the trend over at least three years.
Loading interactive…
Change net income and net sales and watch the profitability ratios move. Then raise owner's equity and see how return on equity falls even though profit has not changed.

Worked examples

Reveal one step at a time and try to beat it to the next line.

Example 1
Birch Lake Corp. earned net income of $260,000 in 2026 and declared $20,000 of preferred dividends. It had 100,000 common shares on January 1 and issued 30,000 more on April 1. Find the weighted average common shares and EPS to the nearest cent.
Example 2
At December 31, 2026, Birch Lake Corp.'s total shareholders' equity is $1,500,000, of which $200,000 is preferred shares (no dividends in arrears). There are 130,000 common shares outstanding. The share price is $25.00 and common dividends were $0.80 per share. Find book value per common share, the P/E ratio (using EPS of $1.96) and dividend yield.
Example 3
Using Maple Outdoor's figures, compute ROA and ROE to one decimal place and explain why they differ. Net income $75,000; total assets $600,000 (2025) and $700,000 (2026); equity $320,000 (2025) and $390,000 (2026).

Where marks get lost

  • Forgetting to subtract preferred dividends from net income when calculating EPS.
  • Using year-end shares instead of the weighted average for EPS when shares were issued during the year.
  • Using a weighted average, instead of shares outstanding at year end, for book value per share.
  • Using ending total assets instead of average total assets for return on assets.
  • Treating a high P/E as proof a share is overpriced, or a low one as proof it is a bargain, without looking at growth and risk.

Flashcards 9

Gross profit margin
Net profit margin
Return on assets
Return on equity
+ 5 more

Practice

1
Net income is $180,000, preferred dividends are $30,000 and the weighted average number of common shares is 60,000. What is EPS? Answer to the nearest cent.
$
2
A company had 80,000 common shares on January 1 and issued 24,000 more on July 1. What is the weighted average number of common shares for the year? Answer as a whole number.
shares
3
Net income is $54,000. Total assets were $420,000 at the start of the year and $480,000 at the end. What is return on assets? Answer as a percent to one decimal place.
%
4
Total shareholders' equity is $900,000, including $150,000 of preferred shares. There are 50,000 common shares outstanding. What is book value per common share? Answer to the nearest cent.
$
5
A share pays dividends of $1.20 per year and trades at $48.00. What is the dividend yield? Answer as a percent to one decimal place.
%
6
Net sales are $1,250,000 and net income is $87,500. What is the net profit margin? Answer as a percent to one decimal place.
%
7
Two companies in the same industry have identical sales and expenses, but one uses straight-line amortization and the other uses declining-balance on new equipment. Which limitation of ratio analysis does this illustrate?
8
Company A has a P/E of 30 and Company B a P/E of 10, in the same industry. What is the most reasonable interpretation?
9
Match each question to the ratio that answers it.
How much profit does each dollar of sales keep after all expenses?
How well does management use all the company's assets?
How much profit belongs to each common share?
How much are investors paying for each dollar of earnings?
What cash return do dividends give on the share price?

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