Chartered Financial Analyst (CFA) Level 1 Practice Exam

What do profitability ratios measure?

1. The company’s ability to manage expenses

2. The company’s ability to generate profits from its assets

3. The company’s ability to repay debts

4. The company’s ability to grow revenue

The correct answer is: The company’s ability to generate profits from its assets

Profitability ratios are essential indicators of a company's financial performance, specifically measuring its ability to generate profits relative to its sales, assets, or equity. By focusing on option B, we acknowledge that these ratios reflect how effectively a company uses its assets and resources to produce profit. Key profitability ratios include net profit margin, return on assets, and return on equity. Each of these provides insights into how well a company turns its resources into earnings, which is crucial for assessing financial health and operational efficiency. This understanding is foundational for investors and analysts evaluating a firm's performance over time or in comparison to industry peers. Other options, while they touch on important aspects of financial analysis, do not specifically characterize profitability ratios. For instance, the management of expenses relates more to operational efficiency than profit generation. Similarly, evaluating a company's ability to repay debts falls into liquidity and solvency analyses rather than profitability. Lastly, finding a company’s ability to grow revenue is more aligned with growth metrics rather than directly measuring its profitability. Thus, option B accurately captures the essence of what profitability ratios measure.