Profitability Indicator Ratios

Before we talk about what profitability is, we need to understand why it matters.

A business exists to add value. Of course, a business has dozens of other identities: It could be an employer, a taxpayer, an intellectual property thief, a B Corporation bent on doing environmental or social good.

But it’s still a system underneath; an economic machine that, like a bicycle, combines a set of inputs in a way that yields a result – a value – whose sum is greater than the parts.

We measure this value with profit. It’s literally the most important concept for an investor to understand.

But what exactly is profit? The definition in economics textbooks is revenues minus expenses.

That definition – the accounting definition – is true, and it is useful for per-unit analysis and capital budgeting. But for an investor, that definition alone doesn’t capture the full economic value added by the company.

In the sections that follow, we’ll explain the various income statement-style definitions of profit, their strengths, uses, and inadequacies. We’ll discuss why EBITDA is a favorite of investment bankers trying to sell unprofitable companies, and walk through effective tax rates. And most importantly, we’ll dive into the truest measures of value added to a business: Return on Assets, Return on Equity, Return on Invested Capital, and Return on Capital Employed.

Knowing the truth about profitability may not change your life, but it may change your view on investing. At least we hope it will.