Profitability Ratios – What you Need to Know

Balance Sheets and Income statements seem to be frightening and a morass of numbers to most people, unless you know how to look at it in the right way. To make sense of these numbers and to evaluate a company’s financial strength or weakness, to get insights into possible stock market performance – you must look at the relationships between the figures. The ratios discussed in this series of articles are the most frequently used by financial analysts. This article will be focused on Profitability Ratios.

Gross Margin

Gross profit is the difference between Sales and Costs of Goods Sold. The Gross profit margin or just Gross margin is Gross profit divided by Sales. The gross profit margin is an excellent ratio for comparing profitability across companies or over time for one company.

Assuming that Sales totaled $100,000 and COGS (Cost of Goods Sold) totaled $70,000, the Gross margin is 30% for that year.

Profitability Ratio - Gross Margin

That is, gross profit is 30% of sales. When making comparisons, it’s important to remember that Gross Margins differ dramatically by industry. For instance, Gross Margins tend to be very high for biopharmaceutical companies and very low for discount retailers.

Operating Profit Margin

The operating profit margin, also referred to as the operating margin, is a measure of management’s effectiveness in controlling the expenses associated with normal operations. Typically, Cost of Goods Sold, and Selling, General & Administrative Expense are the expenses under management’s control in day to day operations. So, the operating profit is calculated by subtracting COGS and SGA from sales:

Profitability Ratio - Operating Profit Margin

In other words, for every $1 in sales, the company generates $0.12 in operating profit. Operating margin improvement—known as margin expansion—is generally a favorable indicator for a company. Margin expansion can imply:

  1. the company has increased sales with a smaller percentage increase in costs.
  2. management was able to raise the price of its products without losing business.
  3. management has found ways to reduce costs.

Operating profit is sometimes referred to as EBIT, which stands for earnings before interest and taxes. Interest and taxes are not considered operating expenses. EBIT is a commonly used investment term.

 

Net Profit Margin

Net profit margin may also be referred to as profit margin after taxes, net margin or net return on sales. It has about the same meaning as the pretax profit margin. The only case where it would make a difference when comparing two companies is if the two companies have differing tax rates. When the companies being compared have approximately the same tax rate, the analyst can use either the pretax or after-tax profit margin with the same comparative results.

Profitability Ratio - Net Profit Margin

Return on Invested Capital

To measure how well a company is investing its capital, we can look at the after-tax income (return), divided by the invested capital. For now, invested capital means the amount of long term debt plus equity carried on the balance sheet. Recall that capitalization may be thought of as the sources of money that bought the capital assets (i.e., the machinery and equipment that the company uses to make its finished goods). Therefore, return on capital is measure of how efficiently the company is able to use its assets to generate profit.

Assuming the Net profit after tax was $5,000 and the Total Capitalization was $120,000, the Return on Invested Capital was 4.2%.

Profitability Ratio - ROI

Some analysts believe that using average total capital (an average of the capital at the beginning of the year and the end of the year) gives an even more accurate measure. This is because the amount of capital in a company is changing continuously during the year.

This return on invested capital (ROIC) or simply return on capital (ROC) is a measure of the operating profit generated on the capital that was provided by both debt and equity holders.

Return on Equity

The Return on Equity (ROE) ratio looks at profitability from the perspective of the stockholder. To calculate ROE, Net Income is divided by the book value of Shareholder’s Equity.

Profitability Ratio - ROE

Assuming the Net Income for a Company was $5,000 and the Book-Value of the Shareholder’s equity was $90,000, for every $1 in equity the company is generating nearly $0.056 in net earnings or profit.

Return on Assets

A related measure is return on assets or ROA, which is measures how effectively management is using company assets to generate net income.

For net income of $5,000 and Total Assets of $140,000, the ROA is 3.6%. Meaning $0.036 profit for every $1 in assets.

Profitability Ratio - ROA

This is a good ratio to use to compare companies in the same industry, or to watch one company over time. Because some businesses, such as automobile manufacturers, need a high level of assets (are asset intensive) and other industries need lower levels of assets, the Return on Assets ratio is seldom appropriate for comparing companies in different industries.

 

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