Saturday, December 4, 2010

Profitability Ratios

Profitability Ratios measure the company’s use of its assets and control of its expenses to generate an acceptable rate of return. The purpose of these ratios is to help us identify how profitable an organization is. As an investor I would like to invest only in company’s that are profitable and in best case profitable than all their industry peers.

Some of the ratios that can help us identify a company’s profitability are:

1. Gross Margin or Gross Profit Margin
2. Operating Margin or Operating Profit Margin or Return on Sales (ROS)
3. Profit Margin or Net Profit Margin
4. Return on Equity (ROE)
5. Return on Investment (ROI)
6. Return on Assets (ROA)
7. Return on Assets DuPont (ROA DuPont)
8. Return on Equity DuPont (ROE DuPont)
9. Return on Net Assets (RONA)
10. Return on Capital (ROC)
11. Risk Adjusted Return on Capital (RAROC)
12. Return on Capital Employed (ROCE)
13. Cash Flow Return on Investment (CFROI)
14. Efficiency Ratio
15. Net Gearing or Gearing Ratio
16. Basic Earnings Power Ratio

Gross Margin or Gross Profit Margin:

Gross margin or gross profit margin is the difference between the sales and the production costs of the company after excluding overhead, payroll, taxation, and interest payments. It expresses the relationship between gross profit and sales revenue. It is a measure of how well each rupee of a company's revenue is utilized to cover the costs of goods sold.

Higher gross margins for a manufacturer reflect greater efficiency in turning raw materials into income.

Most company’s work towards attaining a particular gross profit margin or bettering it. So in many cases, the selling price of the finished goods is determined based on the margin that the company wishes to attain by selling these goods.

Example: Let us say Mr.X manufactures leather belts and sells them to retail show-rooms. The cost that Mr.X incurs during the production of a single premium quality belt is Rs. 400/- He wishes to maintain a profit margin of 25% on his products. So the price he would sell his belts to his retailers is Rs. 500/-


1. Gross Profit / Net Sales or
2. (Net Sales – COGS) / Net Sales

Operating Margin:

Operating Margin is a measurement of what proportion of a company’s revenue is left over, before taxes and other indirect costs are incurred, after paying for variable costs of production like wages, raw materials etc.

A good operating margin is required for a company to be able to pay for its fixed costs like interest on its debt. A higher operating margin means that the company has less financial risk.


Operating Margin = (Operating Income / Revenue)

Operating income is the difference between operating revenues and operating expenses

Net Profit Margin:

Net Profit margin is an indicator of the profitability of an organization. This refers to the actual amount of profit the company makes after deducting taxes and operating expenses. All company’s strive to attain a good or rather high net profit margin. A net profit margin is also an indicator of the ability of the organization to control cost and also a good pricing strategy.


Net Profit Margin = (Net Profit (After Taxes)/ Revenue) * 100%

Note: It is easy to confuse gross profit margin and net profit margin. Gross profit is the amount of money left after paying for the operating expenditure. Net profit is the amount of money left after paying for operating expenses as well as government taxes. This is the actual amount of profit that goes into your pocket.

Return on Equity:

Return on Equity is a measure of the returns generated by every share of common stock of a company. High ROE does not mean any immediate benefits but an increasing ROE year-on-year means that the company is doing well and is able to grow on its profits.


ROE = Net Income / No. of Shares

Net Income – This is the total income of the company after paying preferred stock dividends
No. of Shares – This is the total number of common shares in the market (Does not include Preferred Shares)

Return on Investment:

Return on Investment or Rate of Return or just return is the ratio of the money gained or lost on an investment relative to the amount of money invested. In business perspective, return on investment is the amount of money earned relative to the amount of money put up as capital. ROI is usually expressed as a percentage.


ROI = Net Income/Average Owners Equity or

ROI = Net Income/Invested Capital

Return on Assets:

Return on Assets percentage shows us how profitable a company’s assets are in terms of generating revenue. This number tells us what the company can do with the assets it has i.e., how many rupees the company has earned based on every rupee of asset they control. It is a useful number for comparing two evenly matched or competing companies in the same industry. This number may vary widely when we compare companies across industries. Usually companies in capital intensive industries will have lower return on assets.


ROA = Net Income from Assets / Total Assets

Return on Assets DuPont:

Return on Assets DuPont is a ratio that shows how the return on assets depends on both asset turnover and profit margin. The DuPont Method or Formula breaks out these two components (asset turnover & profit margin) in order to determine the impact of each on the profitability of the company. This ratio helps to highlight the impact of changes in asset turnover and profit margin.


ROA DuPont = (Net Income/Sales) * (Sales/Total Assets)

Return on Equity DuPont:

DuPont Corporation created this type of calculation for Return on Equity. This theory breaks down ROE into three distinct elements. This analysis enables the analyst to understand the source of superior (or inferior) returns by comparison with companies in the same industry or even between industries.


ROE DuPont = Profit Margin * Asset Turnover * Equity Multiplier

Profit Margin = Net Profit / Sales
Asset Turnover = Sales / Assets
Equity Multiplier = Net Profit / Equity

Return on Net Assets:

The Return on Net Assets is a measure of the financial performance of a company that considers the use of its assets into account. The assets the company has at its disposal is also considered as a source of income while calculation of this parameter. Higher the RONA, the better it is for the investors. This directly means that the company is putting its assets to effective use and is generating additional revenue out of the assets rather than let them stay idle like say in a bank account.


RONA = Net Income / (Fixed Assets + Working Capital)

If you see this formula, the working capital is also taken into consideration. This is because; the company is anyways using its working capital to generate revenue/income. This number RONA would equate to the Return on Investment if the company’s assets are generating zero revenue.

Return on Capital:

Return on Capital is a financial measure that qualifies how well a company can generate cash flows (income) relative to the capital that was invested in the business. Here capital invested includes all monetary capital invested into the business like long-term debt, common and preferred shares etc.

When the ROC is greater than the cost of capital, the company is generating value a.k.a, the company is making profits. Whereas if the ROC is less than the cost of capital, the company is making losses.


ROC = (Net Operating Profit – Adjusted Taxes) / Invested Capital

ROC is usually indicated as a percentage.

Risk Adjusted Return on Capital:

RAROC is a risk based profitability measurement for analyzing the risk-adjusted financial performance of the company and for providing a consistent view of the profitability across businesses. RAROC is usually used in banking parlance where companies have to handle the risk of losses.

In business enterprises, risk is traded off against benefits. RAROC is defined as the ratio of risk adjusted return to economic capital. The economic capital is the amount of money which is required to secure the survival of the organization in a worst case scenario; it is a buffer against expected shocks in the market values. Economic capital is a function of credit risk, market risk and operational risk and is often calculated by VaR (Value at Risk). This use of capital based on risk improves the capital allocation across the different functional areas of banks, insurance companies or any other business in which capital is placed at risk for an expected return above the risk-free rate.


RAROC = Expected Return / Economic Capital or
RAROC = Expected Return / Value at Risk

Return on Capital Employed:

ROCE compares the earnings of the company based on the capital invested in the company. We compare the pre-tax operating income and the money invested as capital to run the business to derive the ROCE


ROCE: EBIT / Capital Employed

EBIT – Earnings before Interest and Taxes
Capital Employed – This is actually the capital investment required to run the company. It can be shareholder funds, bank loans and other debt etc

Capital Employed = Total Assets – Current Liabilities

Cash Flow Return on Investment:

CFROI is a valuation that assumes that the stock market sets prices based on the company's cash flow and not on the corporate performance and earnings. It is calculated by comparing the gross cash flow generated by the company and the gross investment done into the same.


CFROI = Gross Cash Flow / Gross Investment

Here Gross Investment refers to the Market Capitalization of the company.

Efficiency Ratio:

Efficiency ratio is a ratio that is usually applied to banks. It is used to determine how effectively an organization is able to carry out its operations. It is calculated by comparing the operating expenses and the revenue. A lower percentage is always better because it means lower expenses and higher earnings.


ER = Expenses / Revenue

Net Gearing:

Also called as Gearing Ratio, this ratio is used to identify the financial leverage of the company i.e. to identify the degree to which the firm’s activities are funded by the owners money versus the money borrowed from creditors.

The higher a company’s degree of leverage, the more the company is considered risky.


Gearing Ratio = Net Debt / Equity

Basic Earnings Power Ratio:

The basic earning power ratio (or BEP ratio) compares earnings apart from the influence of taxes or financial leverage, to the assets of the company. It is just a ratio of the earnings of the company and its assets and does not include the capital invested into the company or the tax and interest liabilities.


BEPR = EBIT / Total Assets

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