What’s it: Profitability ratio is a financial ratio to measure the company’s ability to generate profit. Profitability ratios are a key driver of a firm’s value and hence, an important factor for valuing its share price. As a result, many stock analysts make profitability their focus.
Why are profitability ratios important?
We can answer the following questions by analyzing the profitability ratios.
- Does the company make money?
- Are company’s profits getting better or worse over the years?
- How well is the company converting revenue into profit?
- How well is the company employing its assets and capital to make a profit?
- Is the company more profitable than its competitors?
Profitability ratio is another important financial ratio besides activity, liquidity, and profitability ratios. Stock analysts, creditors, shareholders are closely watching this ratio. An increase in profit is usually identified with generating more cash (please note, profit does not always equal cash under accrual accounting).
An increase in profit can be due to an increase in revenue, a decrease in expenses, or a combination of both. The market likes it when a company can make more profit, leading to an increase in its share price. Meanwhile, for creditors, it means the company can pay its obligations without any problems. And, then, shareholders expect the company to pay more dividends when it posts more profit.
How to calculate the profitability ratio?
Calculating the profitability ratio is relatively easy because it only requires arithmetic operations. The data can be found in the income statement. In addition, we also need to look at the data on the balance sheet to calculate the return on profits, such as total assets. Before discussing formulas, let’s take a moment to discuss what types of profitability ratios are.
What are the types of profitability ratios?
We measure profitability ratios from two perspectives:
- How capable the company is to convert revenue into net income (net profit).
- How capable the company is to generate profits using the assets it owns.
The first point evaluates the profit margin. To get the numbers, we compare the profit measures to sales/revenues, which underscores how well the company is converting sales into profits. Some of the commonly used profit margins are:
- Gross profit margin
- Operating profit margin
- Net profit margin
In addition to the three measures above, there are several variations of profit margins, including EBIT margin, EBITDA margin, pre-tax margin, and NOPAT margin. And, the calculation is also the same, where we divide EBIT, EBITDA, NOPAT by revenue. So then, the inference from them is also the same, in which the higher ratio is preferred.
Back again to the previous two points.
The second point evaluates the returns generated by the company. We measure it by comparing net income with items on the balance sheet, including total assets, total invested capital, and total equity. Commonly used return measures are:
- Return on assets (ROA)
- Return on equity (ROE)
- Return on invested capital (ROIC)
What is the formula for the profitability ratio?
Now, let’s discuss the examples of profitability ratios above one by one. First, the initial section discusses profitability margins. Then, we’ll talk about profit returns.
Gross profit margin
Gross margin or gross profit margin shows what percentage of dollars is left after paying for direct inputs to generate revenue. Gross profit is equivalent to revenue minus the cost of goods sold (COGS), i.e., costs directly related to producing goods or delivering services. The figures are found in the income statement.
We calculate gross profit margin by dividing gross profit by revenue. The mathematical equation is as follows:
- Gross profit margin = Gross profit / Revenue
A higher gross profit margin is preferable because more dollars are available to pay other expenses such as operating expenses, interest and taxes. Conversely, the opposite conclusion holds if it is lower.
But remember, gross profit margins will vary widely between industries. Some industries have higher margins while others are lower.
In addition, different competitive strategies can result in different profit margins. For example, a differentiation strategy usually leads to higher margins because the company sells its products at a premium. Thus, the profit per unit sold will be high.
In contrast, cost leadership strategies tend to have lower gross margins because the company sells its products at industry average prices. As a result, the profit per unit is lower than under the differentiation strategy. To achieve the targeted profit, the company is trying to increase the sales volume.
Operating profit margin
Operating profit equals the difference between gross profit and operating expenses, including selling, general and administrative expenses. To calculate the margin, we divide it by revenue.
Operating profit margin measures a company’s profitability from its core business. It gives us insight into how many dollars a company makes from its operations, expressed as a percentage. In addition, it provides a deeper picture of financial performance because it considers all operating expenses, both direct and indirect costs.
Selling, general and administrative expenses represent fixed costs. Therefore, the company has to pay for it regardless of whether it produces or not.
Here is the calculation formula:
- Operating profit margin = Operating profit / Revenue
A higher operating profit margin is better because it indicates more dollars available to pay for non-operating expenses such as interest and taxes. Then, the company can distribute some as dividends and the rest held as internal capital.
Furthermore, suppose the operating profit margin increases from year to year, and the percentage increase is higher than the increase in gross profit margin. In that case, it indicates the company successfully controls operating costs.
Net profit margin
Net profit margin or net income margin reveals how many dollars a company generates after covering all its operating and non-operating expenses. We can find the net income figure at the bottom of the income statement. To get the margin figure, we divide it by revenue.
- Net profit margin = Net profit / Revenue
As with the gross profit margin and operating profit margin, a higher net profit margin is better because the company makes more profit after paying all its bills. The company can keep it as internal capital to support future growth. And, some can be distributed as dividends to shareholders.
The net profit margin is generally vulnerable to spikes in non-operating income/expenses. For example, when a company posts divestiture proceeds, it will increase net income but not operating profit. Thus, the net profit margin appears to have increased significantly compared to the previous year, even though this was not the case with the operating profit margin.
For this reason, it is important to examine the reasons why the increase in net income occurred, whether due to an increase in operating or non-operating profit. Moreover, such an increase occurred once and did not continue in subsequent periods. As a result, the net profit margin looks volatile.
Return on Assets (ROA)
ROA compares net income to total assets. Usually, as the denominator, we use the average of total assets in the last two years instead of a single point in time.
ROA describes how much return for each asset used to generate income. Ideally, companies accumulate assets to generate more sales and profits. An increase in assets indicates higher economies of scale, which helps lower costs, increase profit margins, and increase profits faster than assets, increasing ROA.
Here is the mathematical formula for ROA:
- ROA = Net profit / Average total assets
Higher ROA is better, indicating the company is making more profit for each asset employed. On the other hand, a lower ratio is less preferable.
Return on Equity (ROE)
ROE gives us insight into a company’s ability to generate returns to shareholders on their equity investments. We calculate it by dividing net income by total equity.
Some companies may finance their assets with debt instead of equity. Then, when it can generate more revenue and profit, ROE will rise as net income increases while total equity remains unchanged.
However, companies also can’t take on too much debt to increase ROE. Excessive debt increases financial risk and weakens the company’s ability to pay debts. Moreover, the company must continue to pay debts regardless of whether it generates revenue or not.
The mathematical formula for ROE is as follows:
- ROE = Net profit / Average total equity
Higher ROE figures are more desirable because more profits are available to shareholders.
Another variation of ROE is the return on common equity (ROCE). ROCE only takes into account the profits available to common stockholders. So, first, we subtract net income by preferred stockholders’ dividends to calculate it. Then, we divide it by total common equity instead of total equity.
- Return on common equity (ROCE) = (Net profit – Preferred dividend) / Average common equity
Return on invested capital (ROIC)
ROIC measures how many dollars are made for each invested money. Invested capital, broadly speaking, is divided into two: equity capital and debt capital. Thus, we calculate the invested capital by adding the total debt plus the total equity.
Then, to get the ROIC, we divide the EBIT by the total investment.
- ROIC = EBIT / Average total investment
We use EBIT to account for all recorded profits before paying as interest or tax. It is more informative than using net income as the numerator because it re-enters interest, which is a return to creditors. Another alternative to EBIT is Net Operating Profit After Tax (NOPAT).
Higher ROIC is better, indicating the company is effectively using its capital to generate profits. If it is higher than the cost of capital – usually measured by the weighted average cost of capital (WACC) -, the company creates value.
How to use this ratio?
Comparing the above ratios from year to year provides insight into how well a company’s financial performance is in relation to its ability to generate profits. And, accompanied by efficiency ratios, we can get a deeper picture of how efficiently a company uses its assets internally to generate profits.
In addition to comparing the numbers historically, these ratios will give us more information if we compare them to peers or industry averages. Higher numbers relative to competitors or industry averages indicate that the company performs better in posting profits.
Then, we must also understand the characteristics of the industry in which the company operates. Take the case of retail companies or hospitality companies. Profit margins may rise and fall from quarter to quarter as their revenue will usually tend to be seasonal, where the final quarter may be the peak. Retailers posted lower margins in the early quarter and will rise in the final quarter following higher revenue gains during the holiday season.
So, if we compare the gross profit margin for the quarter in one year, it can be biased. This is because the gross profit margins will appear to be improving in the year (though in reality not when compared to the previous period). For that reason, we should compare it with the same quarter in the previous year because it will be more informative.
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