Ratio of Net Profit to Net Worth

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Business owners use ratios to determine success.
Business owners use ratios to determine success. (Image: PhotoObjects.net/PhotoObjects.net/Getty Images)

Business owners use ratio analysis to determine the financial well being of their companies. Ratio analysis provides an objective measure of the financial effectiveness of its marketing strategies. Ratio analysis is also used by banks and financial institutions to determine the credit worthiness of companies before loans are approved.

Net Profit Ratio

Determined by dividing net profit by net sales and multiplying the resulting ratio by 100. Net profit is determined by subtracting total expenses from a company's total sales revenue. Net profit ratio is an indicator of a company's profitability and indicates to investors a company's ability to respond to difficult market forces and maintain profitability. Net profit ratio should not be used as a sole indicator of company health, but must be compared to the financial investment it took to make the profit.

Net Worth Ratio

The net worth ratio is used to analyze the effectiveness of a company's utilization of shareholder investment to create a positive return on the investment. The ratio is determined by a formula that divides net profit after taxes by shareholder investment plus retained earnings. Retained earnings are a percentage of net earnings not paid out as dividends but that are retained to reinvest in the company or pay down debt. A high net worth ratio indicates to investors there may be excessive risk in investing in the company.

Significance

The net profit to net worth ratio is determined by dividing net profit by net worth and multiplying the result by 100. This ratio is one indicator of how well a company is using its assets to make a profit. If the ratio indicates that a disproportional amount of company assets are being used to earn a profit, then actions must be taken to increase productivity for each dollar invested. This ratio helps investors determine if a company is effectively managing its assets.

Consequences

Companies that are unable to consistently earn a profit will be forced to sell off or expend assets to continue operations. Assets that are sold off or expended reduce a company's net worth. Revenue production that uses an inordinate amount of company assets indicates either poor management strategies, inefficient manufacturing processes, or ineffective sales performance. The ratio of net profit to net worth can be used as an indicator of a company's ability to remain in business for the long term.

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